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1 Module -I
1
INFLATION
Unit Structure:
1.0 Objectives
1.1 Introduction
1.2 Meaning of Inflation
1.3 Features of Inflation
1.4 Causes of Inflation
1.5 Effects of Inflation
1.6 Hyper Inflation
1.7 Demand Pull Inflation and Cost Push Inflation
1.8 Economics of Depression
1.9 Nature of Inflation in Developing Economy
1.10 Phillips Curve
1.11 Summary
1.12 Questions
1.0 OBJECTIVES
To study the meaning, features and effects of inflation.
To understand the concept of hyper inflation.
To study demand pull inflation and cost push inflation.
To understand th e concept Economics of Depression.
To study the concept of Phillips curve.
To study the nature of inflation in developing economy.
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2 1.1 INTRODUCTION
A sustained rise in the general price level over a period of time is known
as inflation. Conversely, a sustained fall in the general price level would
be known as deflation. Inflation is measured in terms of a price index. For
instance in India, we have the wholesale price index (WPI) and the
consumer price index (CPI). The Price Index is based on a basket of goods
and services. Within a given basket, the prices of some goods and services
may rise or fall. However, when there is a net increase the price of the
basket, it is called inflation.
1.2 MEANING OF INFLATION
Inflation is a rate of change in the pric e level. The rate of change is
measured with reference to the base year so that a long term perspective is
obtained with regard to price rise. For all practical purposes, inflation rate
is measured on yearly basis. However, in recent years, the inflation r ate is
also measured on monthly and weekly basis. The rate of inflation can be
measured as:
P = (P1 P0) P0 100.
For example, the price index based on the Wholesale Prices in India for
the year 2003 -04 was 180.3 and in 2004 -05, it was 189.5. The rate of
inflation for the year 2004 -05 was 5.1 per cent. Inflation rate measured on
the basis of wholesale price index (WPI) for the period 2005 -06 to 2012 -
13 in India is given in Table 1.1
Inflation Rate based on Wholesale Price Index (WPI)
in India for the p eriod 2005 -06 to 2012 -13
Year Wholesale
Price Index Inflation Rate (%) P = [(P1 - P0) /P0] x 100 2005-06 104.5 - 2006 -07 111.4 111.4– 104.5/104.5 x 100 = 6.6% 2007 -08 116.6 116.6–111.4/111.4 x 100 =4.6% 2008-09 126.0 126.0 – 116.6/116.6 × 100 = 8.06 2009-10 130.8 130.8 – 126.0/126.0 × 100 = 3.80 201 0-11 143.3 143.3 – 130.8/130.8 × 100 = 9.55 2011-12 156.1 156.1 – 143.3/143.3 × 100 = 8.93 2012 -13 164.8 164.8 – 156.1/156.1 × 100 = 5.57
1.3 FEATURES OF INFLATION
Everyone is familiar with the term Inflation as rising prices. It means the
same thing as fall in the value of money.
According to Crowther,“inflation asa state in which the value of money is
falling, i.e., prices are rising.” munotes.in
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3 There are mainly three features of inflation which has been given as
follows -
1. Continuous rise in prices
2. Excessive supply of money in the economy
3. Vicious circle of inflationary spiral created by the velocity of circulation
of money.
1.4 CAUSES OF INFLATION
The causes of inflation are classified int o two categories. They are demand
side and supply side factors. These factors are discussed in this section.
1.4.1 Demand side Factors Causing Inflation:
Inflation is caused by a rise in aggregate demand over aggregate supply.
Factors causing in aggregate demand over aggregate supply are as follows.
1. Increase in Public Expenditure:
Public expenditure has been increasing by leaps and bounds since the
emergence of the Welfare State in the second half of the 20th century.
Particularly in mixed economies wit h a pre -dominant public sector, the
rise in public expenditure has been phenomenal. The interventionist role of
the State has increased over time and the governments are seen to be
responsible for building social and economic infrastructure.
For instance, Government expenditure has regularly increased in India.
The Government expenditure in India has continuously increased since the
beginning of economic planning. Rising government expenditure has been
an important cause of inflation in India. The governmen t or public
expenditure was 15.3 per cent of GDP in 1960 -61 and since then it has
been on a continuous rise. In 1990 -91, it was 31 per cent of the GDP. It
further rose to 31.2 per cent in 2000 -01. About 48% of the public
expenditure inz India is on non -developmental activities. Expenditure on
defense, interest payments and governmental machinery constitutes non -
developmental expenditure. Expanding governmentalmachinery, rising
defense expenditure, expenditure on subsidies and growing public borrowing
has cont ributed to the rise in non -developmental expenditure. While non -
developmental expenditure increases aggregate demand in the economy, it
does not increase aggregate supply and hence price rise.
2. Deficit Financing:
There is no surplus or even a balanced budget. Governments do not spend
according to their incomes. Government budgets are always deficit budgets
which means, government expenditure is always greater than income.
Increasing fiscal deficit is a general feature of the government budgets of
develop ing countries. In order to finance the budget deficit, governments take
recourse to public borrowing and also borrowing from their Central Banks.
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4 the existing tax rates or raise ne w taxes. Deficit financing leads to rise in
public expenditure and hence rise in aggregate demand, thereby causing
inflation.
For example, the expenditure of the government of India has been more
than its income. The gap between expenditure and income or t he deficit is
filled through deficit financing. The deficit is financed by borrowing
funds from the banking system. If the borrowed funds are used for
unproductive purposes, they will give rise to inflation. The government of
India has used the borrowed fu nds for non -developmental purposes in a
careless manner. The fiscal deficit during the year 2002 -03 was
Rs.145072 crore and in the year 2007 -08, it was Rs.150948 crore.
3. Increase in Money Supply:
Increase in money supply over and above the quantity of outp ut
produced in the economy would result in price rise. Irving Fisher’s
quantity theory of money explains how increase in money supply without
a proportionate increase in output leads to rise in prices and fall in the value
of money. Commenting on the effec t of money supply on prices, Dr. C
Rangarajan, former Governor of the Reserve Bank of India states that
“Money has an impact on both output and price. The process of money
creation is a process of credit creation. Money comes into existence because
credit is given either to the government or the private sector or the
foreign sector. Since credit facilitates the production process, it has favorable
impact on output. But at the same time the increased money supply raises the
demand with an upward pressure on prices”. Dr. Rangarajan has
therefore accepted the fact in India, price effect of money supply is greater
than output effect.
If increase in money supply was the only reason for rising prices then the rise
in prices should be equal to the difference betwee n the increase in money
supply and increase in output. In the Indian context, no such
relationship is found between the increase in money supply and
the inflation rate. For instance, the inflation rate in the year 2004 -05
was 5.1 per cent and the excess of money supply over real GDP was
only 4.8 per cent. Going by Irving Fisher’s formula, the inflation rate
must be equal to excess money supply. However, in the Indian
context, the inflation rate was slightly higher than the excess money
supply. In subsequent years, it is surprising to find that the inflation
rate has been much lower than the excess of money supply over
real GDP. Divergence between excess money supply and the inflation
rate is brought out in Table 6.2. It clearly means that there are other
factors also which lead to increase in prices.
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5 Table 1.2
Comparison between Money Supply, Real GDP and Inflation Rate
in India
Year Increase in
Money
Supply
M3 (%) Change in
GDP (%)
at 1999 -
2000 Prices Excess of
Money
Supply
Over Real
GDP (%) Inflation
Rate
(WPI
based)
2003 -04 -
2004 -05 12.3 7.5 4.8 5.1
2005 -06 17.0 9.4 7.6 4.1
2006 -07 21.3 9.6 11.7 5.9
2007 -08 22.4 8.7 13.7 4.1
(Source: IES 2007 -08)
4. Corruption and Black Money:
Financial corruption leads to creation of black money. Corruption by
public servants and ministers amounts to unearned income and
leakages in the system. Any leakage in the flow of production would
reduce the total quantity of output and increase in aggregate
demand. Further unreported incomes or black money would also
cause rise in prices. Although unreported incomes are not entirely
unearned incomes, they do contribute to excessive consumption
expenditure and therefore cause rise in prices. \
According to Transparency International, India and Centre for Media
Studies; Ind ia Corruption Report 2007, the below the poverty line
households (BPL) in India paid a total bribe of Rs.8830 million to
obtain public services in the year 2007. This amount is only the tip of
the iceberg. Out of the 180 countries surveyed by Transparency
International for corruption, India’s rank was 74 with an index of 3.5
in the year 2006. An index of 10 indicates complete freedom from
corruption and an index of zero indicates total corruption. Countries like
Finland, Denmark and New Zealand with a CPI (c orruption perception
index) score of 9.4 were found to be least corrupt. Countries with a CPI
score of less than five are considered to have serious problem. India is
therefore one of the most seriously corrupted countries in the world.
Myanmar and Somalia w i t h a C P I s c o r e o f t w o w e r e t h e most corrupt
countries of the world.
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6 1.4.2 Supply Side Factors Causing Inflation:
Supply lags in the economy causes aggregate supply to fall short of
aggregate demand and cause price rise. These supply side causes are as
follows.
1. Fluctuating Agricultural Growth:
The rate of growth of output of food grains must be equal to the rate of
growth of demand for food grains. Demand for food grains increases due to
rise in incomes and rise in population. In poor countries, the income
elasticity of demand for food grains is high. In poor countries, the
agricultural sector is under -developed and largely dependent on
nature. Thus when the agricultural sector fails to produce adequate output, the
prices of agricultural goods rise.
In the Indian context, population growth rate and the rate of growth of
agricultural output has remained the same in the last twenty years. Indian
agriculture is dependent on monsoons. Thus bad and poor monsoons mean
crop failure and rise in food prices lea ding to rise in the general price level in
the country. In the year 2004 -05, food production fell by seven per cent. In
the subsequent two years, food production was by 5.2 and 4.2 per cent but
once again fell to 0.9 per cent in the year 2007 -08. The growt h in real
national income was much higher than the rise in food production thereby
causing the prices to rise.
2. Hoarding of Essential Goods:
When the agricultural sector fails, food pries begin to rise more rapidly
than non -food prices. The problem of food price rise is compounded by
hoarding of agricultural goods by traders. Artificial scarcity is created by
both whole -sellers and retailers. As a result, there is much greater
increase in prices than what is justified by real shortages. In the
Indian contex t, both the big farmers and agricultural traders indulge in
hoarding of agricultural goods during the periods of crop failure. In times
of food scarcity, hoarding of food grains and other food products only helps
the prices to rise further.
3. Inadequate Rise in Industrial Production:
In the prosperity phase of the business cycle, there is a sustained
rise in investment demand which causes a sustained rise in demand for
industrial goods. If the capital goods industry fails to respond to the
rise in demand, the prices of industrial goods will rise and when the prices of
industrial goods goes up, the prices of consumer goods also rise. In the
Indian context, during the period 1995 -96 to 2001 -02, the industrial sector
registered slow growth. Inadequate increase in industrial production has
also been an important cause of inflation in India.
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7 1.5 EFFECTS OF INFLATION
Inflation is a theft of income of the unprotected segments of the society.
Inflation is therefore a crime against the poor who experience a fall in th eir
real incomes during a period of sustained price rise. Inflation affects the three
most important functions of an economy namely; production, consumption
and distribution in an adverse manner.
(A) Effect of Inflation on Production and Economic Growth:
In economies where labor is largely unorganized, single digit or creeping
inflation will increase profitability and therefore lead to greater investment,
employment, output, income, demand and prices. This is because the
wages of unorganized laboris not indexed to inflation. The real wages
of unorganized labor will always fall overtime during inflation whether
anticipated or not. In the case of unanticipated inflation, the real wages of
organized labor will also fall and may be compensated with a time lag. T he
firms will gain during the intervening period between unanticipated price rise
and its compensation to labor. Thus from the point of view of production
and economic growth, single digit inflation has a positive impact.
(B) Effect of Inflation on Distrib ution of Income and Wealth:
The impact of inflation with regard to distribution of income and wealth is
not even on all sections of the society. In case of labor, the section that
is protected from inflation is the organized labor whose wages and salaries
are indexed to inflation. But unorganized labor is not protected from
inflation and therefore their real incomes decrease on account of inflation.
Similarly, debtors who have borrowed money on fixed interest gain on
account of inflation because real intere st rate falls during a period of rising
inflation while creditors lose because at times the real interest rate may be zero
and even negative. Similarly, people holding ownership capital like equity
shares, balanced and growth funds make capital gains becau se of rising
profits of business enterprises while people holding creditor capital like
bonds, debentures, fixed deposits and income funds lose due to the fall in real
interest rates. Broadly speaking, during an inflationary period, households
lose and fir ms gain. Hence it is said that during inflation the rich
become richer and poor become poorer.
(C) Effect of Inflation on Consumption and Economic Welfare:
Inflation is known as a poor man’s tax. It reduces the purchasing power of
money earned by the poor people and hence their economic welfare. The
workers who do not get compensated for the increase in price rise,
experience reduction in real incomes because their nominal income remains
constant over a long period of time. Even those workers who get
compen sated for the price rise lose purchasing power during the
intervening period between the rise in prices and the compensation in price
rise. For instance, the Central and State Government employees in India
get compensated for inflation twice in a year and there is always a lag of
six months before such compensations are given. Economic welfare
depends upon consumption of goods and services and during a period of munotes.in
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8 sustained rise in prices, the people are able to consume less goods and
services. As a result, t here is a loss of economic welfare.
1.6 HYPER INFLATION
On the basis of the rate of price rise, inflation is classified into five
categories. They are creeping or moderate inflation, walking, running,
galloping and hyper inflation. When the rate of price rise is less than
three per cent per annum, it is called creeping inflation. An inflation rate
of about three per cent per annum is considered creeping. When prices
creep upwards at a moderate rate, inflation serves as an incentive to
investment. As a resu lt, the rate of investment, employment, output and
aggregate demand rises in the economy and the economy moves into the
prosperity phase.
When inflation rate crosses the three per cent mark and remains within
single digits i.e. below the 10 per cent mark, it becomes walking inflation.
Walking inflation leads to a much rapid fall in the purchasing power of
money. However, the negative consequences of single digit inflation are
not widely felt and hence it is considered within the tolerable limits.
However, b oth monetary and fiscal policies are swung into action to
control the rate of inflation and keep it within single digits.
When inflation rate is in double digits, it is known as running inflation.
When prices begin to rise by more than 10 per cent per annum and the rate
of inflation accelerates, money begins to flow away from productive
activities into unproductive or speculative activities. As a result, the supply
of goods and services fall in the economy and their prices begin to rise
more rapidly. Thus commodity prices rise rapidly for want of investment
and prices of gold, real estate and stocks rise more rapidly because more
and more money is diverted from the productive sector to the
unproductive sector.
When prices rise by about 100 per cent annum, th e situation is known as
galloping inflation and when the inflation rate is over 1000 per cent a year,
it is called hyper inflation. Both galloping and hyper inflation signals the
collapse of the economy. Productive activity is at an all time low, people
lose confidence in the currency and the economy looks like more of a
barter economy. During world war one, countries like Austria, Hungary,
Germany, Poland and Russia experienced hyper inflation. For
instance between 1920 -23, the German price index rose from one to one
billion. In 1994, the inflation rate in Georgia was 15000 per cent per
annum. In 2008, the inflation rate in Zimbabwe was 11.2 million per
cent. In such situations, the paper on which money is printed become more
valuable than the money itself i .e. the intrinsic value of even paper money
becomes greater than the face value. Thus if you sell money by kilograms
you may get more money in return than by exchanging money in the
market for goods and services.
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9 1.7 DEMAND PULL INFLATION AND COST PUSH
INFLATION
1.7.1 Demand Pull Inflation:
It may be defined as a situation where the total monetary
demand persistentlyexceeds total supply of real goods and services at
current prices, so that prices arepulled upwards by the continuous upward
shift of the aggre gate demand function.
The demand -pull theorists point out that inflation might be caused by
an increase in the quantity of money, when the economy is operating at
full employment level. As the quantity of money increases, the rate of
interest will fall and consequently, investment will increase. This
increased investment expenditure will soon increase the income of the
various factors of production. As a result, aggregate consumption
expenditure will increase leading to an effective increase in the effectiv e
demand. With the economy already operating at the level of full
employment, this will immediately raise prices, and inflationary forces
may emerge. Thus, when the general monetary demand rises faster than the
general supply, it pulls up prices.
By using the aggregate demand and aggregate supply curves, the demand -
pull process be shown diagrammatically as follows:
Figure No. 1.1
Demand pull inflation
In the above figure, the X -axis measures real output and Y -axis measures
the price level. Aggregate deman d curves are D,D1,and D2
whereas S curve represents Aggregate supply function , which slopes
upward from left to right and at point F it becomes a vertical straight line.
At this point the economy reaches at full employment level. Hence
real output remains same or inelastic at this point. D curve intersect S
curve at point F, where real output or income is at full employment and
OP is the price level. When aggregate demand increases from D to D1 and munotes.in
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10 D2, the real output or income will remain same but the pri ce level tends to
increase from OP to OP1 and further to OP2 . In short the inflationary
process can be described as follows –
Increasing demand increasing prices – i n c r e a s i n g c o s t s –
increasing income – increasing demand – increasing prices – and so on.
Causes of Demand -pull inflation:
1. Increase in public expenditure –
There may be an increase in the public expenditure (G) in excess of public
revenue. This might have been possible through public borrowings from
banks or through deficit financing, which implies an increase in the money
supply.
2. Increase in Investment –
There may be an increase in the autonomous investment (I) in firms,
which is in excess of the current savings in the economy. Hence, the flow
of total expenditure tends to rise, causing a n excess monetary demand,
leading to an upward pressure on prices.
3. Increase in MPC –
There may be an increase in the marginal propensity to consume (MPC),
causing an excess monetary demand. This could be due to the operation of
demonstration effect and su ch other reasons.
4. Increasing export and surplus Balance of Payments –
In an open economy, increasing demand for exports leading to increasing
money income in the home economy. Whereas in the domestic market
there is reduction in the domestic supply of good s because products are
exported. If an export surplus is not balanced by increased savings, or
through taxation, domestic spending will be in excess of the value of
domestic output.
5. Diversification Resources –
A diversification of resources from consumptio n goods sector either to the
capital good sector or the military sector will lead to an inflationary
pressure because the current flow of real output decreases on account of
high gestation period involved in these sectors. The opportunity cost of
war goods is quite high in terms of consumption goods meant for the
civilian sector. This leads to an excessive monetary demand for the goods
and services against their real supply, causing the increase in prices.
1.7.2 CostPush Inflation
It is sometimes also calle d as wage inflation as wages constitute nearly
seventy percent of the total cost of production. When wages rise, it will
lead to rise in cost of production and a consequent rise in the price level. munotes.in
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11 Cost-push inflation can be diagrammatically explained as f ollows.
Figure No. 1.2
Cost push Inflation
Real Output
In the above figure, demand curve D represent the aggregate demand
function and SS represents aggregate supply function. The full employment
level of income is OY. At this F is the point of intersec tion between
aggregate demand and aggregate supply function. When aggregate supply
function shifts upward to S1 it will become a vertical straight line at point G
at full employment level. The new equilibrium point A is determined at
OY1 level of output, which is less than full employment level at P1 level
of prices. This means that with a rise in the price level unemployment
increases. A further shift in the aggregate supply curve to S2 due to
further increase in wages lead to further increase in price to P2 and fall in
income level to OY2.
Cost -push inflation may occur either due to wage -push or profit -
push. When there are monopolistic labour organizations, prices may
rise due to wage -push. When there are monopolies in the product market,
the monopolists m ay be induced to raise the prices in order to fetch high
profits. Then there is profit -push in raising the prices.
Check Your Progress :
1. Define Inflation.
2. What are the various causes of demand -pull inflation? 3. Explain the
causes of cost -push inflation.
1.8 ECONOMICS OF DEPRESSION
Economic depression is a period of sustained, long -term downturn in
economic activity in one or more economies. It is a more severe economic munotes.in
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12 downturn than a recession which is a slowdown in economic activity over
the course of a no rmal business cycle.
The economic depressions are characterized by their length, by
abnormally large increases in unemployment, falls in the availability of
credit (often due to some form of banking or financial crisis), shrinking
output as buyers dry up a nd suppliers cut back on production and
investment, more bankruptcies including sovereign debt defaults,
significantly reduced amounts of trade and commerce (specially
international trade) and highly volatile relative currency value fluctuations
(often due to currency devaluations).
1.9 PHILIPS CURVE
Economic growth without inflation and unemployment is the objective
behind macro -economic policies of modern times. However, in the short
term, there seems to be a trade -off between inflation and unemployment
and hence macro -economic policy makers need to balance between
inflation, economic growth and unemployment. A low inflation rate is
seen to accompany lower economic growth rate and higher unemployment
whereas a high inflation rate is seen to accompany higher economic
growth rate and lower unemployment. Here, in this chapter, we look at the
Phillips curve which was the first explanation of its kind to show the
negative relationship between unemployment and inflation rate. We also
look at the long run picture a nd see whether the negative relationship
sustains in the long run.
In 1958, AW Phillips, a professor at the London School of Economics
published a study of wage behaviour in the United Kingdom for the years
1861 and 1957. Phillips found an inverse relation ship between the rate of
unemployment and the rate of inflation or the rate of increase in money
wages. The higher the rate of unemployment, the lower the rate of wage
inflation i.e. there is a trade -off between wage inflation and
unemployment. The Phillip s curve shows that the rate of wage inflation
decreases with the increase in unemployment rate.
Assuming Wt as the wages in the current time period and Wt+1 in the next
time period, the rate of wage inflation, gw, is defined as follows:
Wt+1 - Wt
Gw= ———— ……..(1)
Wt
By representing the natural rate of unemployment with u*, the Phillips
curve equation can be written as follows:
Gw = - ε (u – u*) ……... (2)
where ε measures the responsiveness of wages to unemployment. This
equation states t hat wages are falling when the unemployment rate
exceeds the natural rate i.e. when u > u*, and rising when unemployment
is below the natural rate. The difference between unemployment and the
natural rate, u – u* is called the unemployment gap. Let us as sume that munotes.in
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13 the economy is in equilibrium with stable prices and the level of
unemployment is at the natural rate. At this point, if the money supply
increases by ten per cent, the wages and the price level must rise by ten
per cent to enable the economy to be in equilibrium. However, the
Phillips curve shows that for wages to rise by ten per cent, the
unemployment rate will have to fall. A fall in the unemployment rate
below the natural level will lead to increase in wage rates and prices and
the economy will ultimately return to the full employment level of output
and unemployment. This situation can be algebraically stated by rewriting
equation one above as follows.
Wt+1 =Wt [1 - ε (u – u*)] ……… (3)
Thus, for wages to rise above their previous leve l, unemployment must
fall below the natural rate. The Phillips curve relates the rate of increase
of wages or wage inflation to unemployment as denoted by equation two
above, the term ‘Phillips curve’ over a period of time came to be used to
describe a cu rve relating the rate of inflation to the unemployment rate.
Such a Phillips curve is depicted in figure no. 1.3.
Figure 1.3
Phillips Curve
Rate of Unemployment (%)
You may notice that when the rate of inflation is ten per cent, the
unemployment rate is three per cent and when the rate of inflation is five
per cent, the rate of unemployment increases to eight per cent. Empirical
or objective data collected from other developed countries also proved the
existence of Phillips Curve. Economists believed that there existed a stable
Philips Curve depicting a trade -off between unemployment and inflation.
This trade -off presented a dilemma to policy makers. The dilemma was a
choice between two evils, namely: unemployment and inflation. In a
dilemma, you chose a lesser evil and inflation is a lesser evil for policy
makers. A little more inflation can always be traded off for a little more
employment. However, further empirical data obtained in the 70s and
early 80s proved the non -existence of Phillips Curve. During this period,
both Britain and the USA experienced simultaneous existence of high Rate of Inflation (%) 9 Phillips Curve 8 - 7 - 6 5 0 1 2 3 4 5 6 PC munotes.in
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14 inflation and high unemployment. While prices rose rapidly, the economy
contacted along with more and more unemployment.
1.11 SUMMARY
1. A sustained rise in the general price level o ver a period of time is
known as inflation.
2. On the basis of the rate of price rise, inflation is classified into five
categories. They are creeping or moderate inflation, walking,
running, galloping and hyper inflation.
3. Keynes explained inflation in terms of demand pull forces. When the
economy is operating at the full employment level of output, supply
cannot increase in response to increase in demand and hence prices
rise.
4. In the absence of rise in aggregate demand, prices may rise due to
increase in cost in terms of higher wages, higher input costs and
higher profits. These are known to be autonomous increases in costs.
Inflation on account of rise in costs is known as Cost push inflation.
5. Inflation affects the three most important functions of an economy
namely; production, consumption and distribution in an adverse
manner.
6. Inflation is the result of excess demand over the supply of goods and
services. Inflation management, however, needs both demand and
supply management as well. Both monetary and fiscal measures can
be adopted to control inflation.
1.12 QUESTIONS
Q1. Explain the concept of inflation and state with example as to how the
inflation rate is measured?
Q2. Explain the concept of Demand -pull inflation and the factors causing
demand pull inflation.
Q3. Explain the concept of Cost push inflation.
Q4. Explain the effects of inflation on production, distribution and
consumption.
Q5. Explain the measures to con trol inflation.
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15 2
STAGFLATION
Unit Structure:
2.0 Objectives
2.1 Introduction
2.2 Meaning of Stagflation
2.3 Causes of Stagflation
2.4 Consequences of Stagflation
2.5 Summary
2.6 Questions
2.0 OBJECTIVES
To understand the meaning of stagflation.
To study the causes of stagflation.
To study the conseq uences of stagflation.
2.1 INTRODUCTION
The Keynesian economics emphasised the importance of adoption of
demand management policies (like monetary and fiscal policies) to fight
either inflation or to solve the problem of unemployment. Keynes was of
the view that true inflation occurs only when the country reaches full
employment. This implies that inflation and unemployment cannot exist
simultaneously.
However, the Phillips Curve established an inverse relationship between
inflation and unemployment. It was not possible for a country to achieve
price stability and full employment at the same time. So, the policy makers
came across the dilemma situation. The rate of inflation could be reduced
only by allowing the rate of unemployment to rise and the rate of
unemployment could be reduced only by allowing the rate of inflation to
rise.
2.2 MEANING OF STAGFLATION
In 1070s most of the advanced capitalist countries of the world faced the
problem of stagflation. It refers to a situation of high inflation and high
unemplo yment, when the rate of growth of GDP itself is low. The
Keynesian policy measures failed to solve this new problem. As a result, a
new school of economics emerged. This is known as the supplyside munotes.in
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Macro Economics - II
16 economics which lays stress on the management of aggregate supply to
fight the disease of stagflation (i.e., inflation in the midst of stagnation).
The term stagflation refers to an economic situation where stagflation and
inflation co -exist. It is characterised with low economic growth, increasing
unemployment an d high rate of inflation. It goes against the conclusion of
Phillips Curve, the inverse relation between inflation and unemployment.
In this we come across a continuous increase in price level and also
increasing rate of unemployment.
Stagflation refers to the coexistence of inflation and unemployment in a
stagnant economy.
The term "stagflation" was first used during a time of economic stress in
the United Kingdom by politician Iain Macleod in the 1960s while he was
speaking in the House of Commons. At the time, he was speaking about
inflation on one side and stagnation on the other, calling it a "stagnation
situation." It was later used again to describe the recessionary period in the
1970s following the oil crisis, when the U.S. underwent a recession that
saw five quarters of negative GDP growth and inflation doubled in 1973
and hit double digits in 1974 unemployment hit 9% by May 1975.
2.3 CAUSES OF STAGFLATION
Economists are not unanimous about the causes of stagflation. To some
supply shocks or cost push a s major factors responsible for stagflation
where as others argued that demand pull is the main reason for this
unusual economic phenomenon known as stagflation. Following are the
factors responsible for of stagflation. The sharp rise in oil price.
1. Supp ly Shock (The Oil Price Hike):
Stagflation refers to the coexistence of inflation and unemployment in a
stagnant economy. A high rate of unemployment means a reduced rate of
output. The problem of stagflation occurred in the context of adverse
supply shock caused by a sudden and a sharp rise in the price of crude oil
in October 1973 by the OPEC (Organisation of Petroleum Exporting
Countries) cartel. A sharp rise in oil price by almost 300% at a time raised
the cost of in oil importing countries and resulted in high prices of several
products. The reason was that oil was used as the main or subsidiary input
in a large number of industries.
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Stagflation
17 Figure No. 2.1
In the above diagram Real GDP(Y)/output is shown on the X -axis and
Aggregate Price Level on the Y -axis. The curve AS is the Aggregate
Supply Curve and AD is the Aggregate Demand Curve. The economy is in
equilibrium at point E where AD curve and AS curve intersect with each
other. At this equilibrium point E, the output in the economy is OM and
the pri ce level is OP. A supply shock such as a sharp rise in oil price
increases the production costs of making goods and services in the
economy. This results in the shift in the AS curve upwards from AS to
AS 1. The new equilibrium point is E 2This results in an increase in price
from OP to OP 1and fall in output from OM to OM 2. In this case the
economy experiences fall in output i.e., increasing unemployment and a
rise in price i.e., inflation. The output falls due to increase in cost of
production and the price level rose due to fall in output and rise in cost.
Thus, there was stagflation -fall in output and employment and cost -push
inflation at the same time. A fall in production leads to unemployment and
the country faces the problem of recession i.e., a situati on of high price
and low demand (due to fall in income).
2. Cost -Push:
Cost of production increases due to many factors besides the above -
mentioned causes. Other factors are increase in wages, price of raw
materials and other inputs. Cost also increases du e to infrastructural
bottlenecks.
3. Low Productivity:
Labour productivity is not only very low but may decline due to protection
provided to the employees by the trade unions and labour laws enacted by
the government. If trade unions have strong bargainin g power – they may
be able to bargain for higher wages, even in periods of lower economic
growth. Higher wages are a significant cause of inflation. Similarly, if an
economy experience falling productivity – workers becoming more
inefficient; costs will ri se and output fall. munotes.in
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Macro Economics - II
18 4. Social Benefits:
Social benefits in the form of unemployment benefits, free supply of
goods and services to the poor, food security schemes, minimum basic
income scheme, provide income to the poor with no obligation to work
create th e problem of inflation. These benefits create more demand
(inflation) and shortage of goods and services (stagflation).
5. Excessive Regulation:
Government policy bringing in excessive controls on production and
distribution and rigid labour laws, results in less availability of goods and
at the same time increase in cost.
6. Higher Taxes:
Government increases its expenditure with additional revenue. Cost of
production increases due to higher tax which may affect supply and/or
demand.
7. Monetary Shocks:
Cheap monetary policy whereby more money is pumped into the economy
at a lower cost result in inflation.
8. Deficit Finance:
Government expenditure more than its revenue leads to more demand for
goods and services resulting in higher prices.
9. Policy C hanges:
Democratic governments with an eye on vote bank may introduce popular
policy measures such as basic income policy, farmers debt waiver, free
electricity, increase in procurement prices and increase in wages and
salaries. All these measures increase demand with less than corresponding
increase in production of goods and services.
10. Rise in structural unemployment:
If there is a decline in traditional industries, we may get more structural
unemployment and lower output. Thus, we can get higher unem ployment
– even if inflation is also increasing.
11. Causes in USA:
Fall in supply of agricultural products, depression of the dollar, removal of
wage and price controls are also responsible for supply shocks in USA
leading to stagflation. Huge military e xpenditure by USA in the wake of
the Vietnam war in the late 1960s, workers expected the rate of inflation to
accelerate in the early 1970s. So, labour unions demanded and succeeded
in getting higher wages which later on created the problem of inflation du e
to increase in purchasing power. This further resulted in higher cost, fall in munotes.in
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Stagflation
19 output and aggregate supply curve shifting to left which finally resulted in
stagflation.
2.4 CONSEQUENCES OF STAGFLATION
1. Stagflation refers to the coexistence of inflation and un employment in
a stagnant economy Stagflation is a situation of inflation in a stagnant
economy. Thus, it has all the negative aspects associated with inflation
and recession. It is a strange situation which neglects the conclusion of
Phillips Curve.
2. It is a situation where economy is stagnant. Output and employment is
stagnant, does not increase, yet prices continue to rise.
3. The economy is in recession state in terms of production and
employment. It means the economy is in stagnant position. While
unemplo yment increases, investment does not respond to the
incentives provided by increase in prices. Decline in investment leads
to less production of goods and services.
4. There is vicious circle of downfall. Less or fall in investment leads to
fall in production which again results in less or fall in income. This
leads to fall in the savings and then further decline in investment.
5. The above explained situation actually should lead to a decline in
price. But on the contrary the price level increase. However, this
inflation does not attract more investment and employment.
6. The economy does not have the advantage of a trade -off between
inflation and unemployment. The relation is direct where people suffer
from twin problems of inflation and unemployment. The product ion
and supply are reduced, bringing down the income and employment
and at the same time pushing the prices up. Any additional money
supply to encourage more production and employment will only result
in increase in prices with hardly any response from sup ply of goods
and services. Following diagram will explain the effects on output and
price.
Figure No. 2.2
munotes.in
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Macro Economics - II
20 Output is shown on the X -axis and the price level on the Y -axis. The
original Aggregate Demand Curve AD 1 cuts the original Aggregate Supply
Curve As 1 at the original equilibrium point E 1. The output is OY 1 and the
price is OP 1. The aggregate supply curve shifts to the left i.e. from AS 1to
AS 2. The new equilibrium point is E 2. The output falls from OY 1 to OY 2
and the price rises from OP 1 to OP 2. Here t he economy experiences both
the stagnation (falling output) and inflation (rising prices). This situation is
termed as stagflation.
If we discuss the situation through Phillips Curve, we will have an upward
sloping supply curve where both price level and u nemployment increase
together.
To bring out the economy out of stagflation the government may require
to adopt a combination of measures which has simultaneous effect on
inflation and stimulating production of goods and services. A judicious
application o f monetary, fiscal and other measures are required to be
implemented.
2.5 SUMMARY
The term stagflation refers to an economic situation where stagflation and
inflation co -exist. It is characterised with low economic growth, increasing
unemployment and high rate of inflation. It goes against the conclusion of
Phillips Curve, the inverse relation between inflation and unemployment.
In this we come across a continuous increase in price level and also
increasing rate of unemployment.
2.6 QUESTIONS
1. Explain the meaning an d causes of stagflation. \
2. Discuss the consequences of stagflation with the help of a diagram.
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21 Module – II
3
MONETARY POLICY
Unit Structure:
3.0 Objectives
3.1 Introduction Meaning of Monetary Policy
3.2 Objectives of Monetary Policy
3.3 Instruments of Monetary Policy
3.4 Limitations of Monetary Policy
3.5 Role of Monetary Policy in Developing Economies
3.6 Summary
3.7 Questions
3.0 OBJECTIVES
To understand the meaning of Monetary Policy.
To see the objectives of Monetary Policy.
To study the quantitative and qualitative instruments of Monetary
Policy.
To see the limitations of Monetary Policy.
To know the role of Monetary Policy i n Developing Economies.
3.1 INTRODUCTION AND MEANING OF MONETARY
POLICY
Monetary policy can be defined as a policy of the Central Bank that
seeks to influence the cost and availability of credit in an economy.
By influencing the cost and availability of credit , by controlling inflation
and by maintaining equilibrium in the balance of payments, monetary policy
plays an important role in increasing the growth rate of the economy.
Monetary policy is an important macro -economic instrument through which
the macro economic objectives of a country is sought to be achieved. The
broad objectives of monetary policy are to obtain economic growth, price
stability, full employment, exchange rate stability and equilibrium in the
balance of payments. Monetary policy influences the supply of money and
the rate of interest in order to stabilize the economy at full employment or near
full employment level by changing the level of aggregate demand in the munotes.in
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Macro Economics - II
22 economy. Business cycles are sought to be controlled with the help of the
tools of monetary policy. Thus, during recession, money supply is increased
and interest rates are brought down to increase the level of aggregate
demand in the economy because it is the level of aggregate demand that
determines the level of employment, output and income in n economy.
Conversely, during the times of high inflation, price rise sought to be
controlled by reducing the money supply and raising the interest rates which
brings about a fall in the aggregate demand and prices. In the context of a
develo ping country l like India, monetary policy aims to achieve sustained
economic growth in the different sectors of the economy.
All countries have a central bank or a reserve bank which formulates and
implements the monetary policy. For instance, in India, i t is the Reserve
Bank of India which is the apex monetary authority of the Indian monetary
system. In the United Kingdom, it is the Bank of England whereas in the
United States, it is the Federal Reserve Bank, popularly known as the
Fed. The objectives of the Fed are no different from the objectives of
any other central bank. Similar to the Reserve Bank of India, the Fed’s
objectives include economic growth according to the expansion potential of
the economy of United States, a high level of employment, sta ble prices
and moderate long term interest rates. The objectives of the Reserve Bank
of India as according to the Chakravarty Committ4eee Report are
economic expansion and inflation control. While economic expansion
ensures growing levels of employment, in flation control ensures price
stability and moderate interest rate. The Reserve Bank of India was
established on 01st April, 1935. The Government of Free India felt that a
State -owned Central Bank will be more conducive to pursue the macro -
economic objecti ves of the government and hence the Reserve Bank of
India was nationalized on 01st January, 1949.
3.2 OBJECTIVES OF MONETARY POLICY
The basic objective of monetary policy is to achieve sustained
economic growth with a fair amount of price stability. The moneta ry
policy is a part of the government’s economic policy. It is formulated and
implemented to achieve the macro -economic objectives. The macro -
economic objectives depends upon the state of the economy i.e. both the
general economic conditions and the sector al and sub -sectoral economic
environment. Suitable monetary instruments are put to work to cater to the
specific requirements of the sectors and sub -sectors of the economy. While
broadly the goals of monetary policy are identical in all capitalist countrie s,
they may be fine tuned to the specific requirements of different countries as
different countries are at different stages of economic growth and
development. Therefore, the broad and general objectives of monetary policy
are economic growth, full employm ent, price stability, exchange rate
stability and equilibrium in the balance of payments. These objectives are
discussed below.
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Monetary Policy
23 (A) Economic Growth
Sustained economic growth is the basic as well as the prime objective of
monetary policy in all countries; ri ch as well as the poor. Sustained
economic growth refers to a continuous growth in the productive capacity of
the economy resulting in a continuous growth in the total quantity of goods
and services produced in an economy. Such a growth process will be
reflected by a continuous rise in the national income as well as the per capita
income of the country. To achieve sustained economic growth, the
Central bank’s monetary policy must aim at maintaining a high level of
aggregate demand in the economy. The moneta ry policy must also induce
high levels of saving and investment in the economy to achieve sustained
growth. The Central bank must ensure that the growth in money supply is in
proportion the proportionate rise in the production of goods and services so that
inflation rates are under control and below the rate of three per cent per
annum.
A moderate inflation of less than three per cent per annum is considered as a
sufficient incentive to higher investment whereas high rates of inflation
lead to more speculat ive activities and less real growth. To maintain and
ensure a sustained growth in aggregate demand, saving and investment in
the economy and to obtain sustained economic growth, the Central bank’s
monetary policy must be flexible to cater to the changing r equirements of the
economy. Thus during a recessionary phase, la cheap monetary policy
must be adopted so that money supply is increased, interest rates are brought
down through a downward revision of the bank rate. Lower interest rates
will encourage high er investment which will lead to higher level of
employment, output, income and demand in the economy. During an
inflationary phase, a dear monetary policy can be adopted and the opposite
impact can be obtained.
In the Indian context, monetary policy can p romote economic growth
by increasing the quantum of credit and by reducing the cost of credit.
Firms need credit to finance their working capital requirements,
importing raw materials and machines and for financing investment in
projects for building fixed capital. Adequate availability of credit at low
interest rates will encourage investment and economic growth. During
the pre -reform period, the Reserve Bank of India followed a tight monetary
policy thereby reducing the supply of credit and increasing the cost of credit.
This policy was given up in the post reforms period by deregulating interest
rates, reducing CRR and SLR and thereby increasing the supply of credit in
the economy. Only lower rates of inflation will lead to low interest rates,
adequate cre dit and growing investment for sustained economic growth. A
consensus has been arrived at with regard to inflation rate i.e.
inflation must be in the 4 to 6 per cent range and low inflation will
ensure economic growth in the country.
(B) Full Employment
The Ce ntral Bank’s monetary policy must be geared to achieve full
employment of all the available productive resources in the economy. munotes.in
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Macro Economics - II
24 However, in reality, the term full employment refers to near full
employment of productive resources or less than full employme nt. It has been
accepted by the economists that about three per cent unemployment is
actually full employment and that absolute full employment is only a
theoretical possibility propounded by the classical economists like JB Say and
others. By stimulating saving and investment, higher levels of employment of
available productive resources can be obtained. However, monetary policy
will be successful only in highly organized and industrialized economies in
achieving higher or near full employment. In the cont ext of developing
countries like India which is predominantly agricultural from the
employment point of view, monetary policy will be irrelevant and sterile in
tackling the problems of seasonal and disguised unemployment which are
substantially high in Ind ia. However, the problem of
unemployment; both seasonal and disguised can be tackled by bringing
about a structural change from the point of view of sectoral composition of
employment. But to bring these changes, monetary policy alone will be not
enough. T he fiscal policy, industrial policy and agricultural policy along
with monetary policy can only solve the peculiar problems of developing
or under developed countries like India.
(C)Price Stability
A capitalist economy is vulnerable to cyclical fluctuation s or business
cycles. Monetary policy must aim at avoiding or neutralizing both the
peaks and troughs of business cycles. The monetary authorities must prevent
the economy from being caught in n inflationary spiral and going down in
deflationary spin. Both inflation and deflation are inimical to the health
of the economy. High rates of inflation or double digit inflation
encourages speculative activity in the economy and channelizes productive
resources into un productive uses along with other attendant evi ls such a s
hoarding, black -marketing, food adulteration etc. Persistent double digit
inflation rapidly erodes the purchasing power of unorganized labor in particular
and results in widening of income inequalities. Similarly, a deflationary spin
would resu lt in falling prices, investment, employment, output, incomes and
aggregate demand. However, a moderate rise in price of less than three per
cent per annum also known as creeping inflation will be consistent with
the objective of achieving price stability. In order to achieve price stability
and at the same time ensure economic growth, the monetary policy needs to
encourage saving and investment but also it should be anti -cyclical in
character. Thus during the times of recession or near zero rates of inflat ion,
the monetary policy must be expansionary and during the times of double
digit inflation a contractionary or tight monetary policy must be pursued.
In the Indian context, Dr. C Rangarajan, former Governor of Reserve
Bank of India, observed that monetar y policy can effectively achieve the
goal of price stability. Higher level of investment is accompanied by
agricultural failures and inflation. Monetary policy therefore has to play an
important role in short run management of the general price level in th e
economy. In the Indian context, price stability refers to moderate rise in
prices i.e. price rise in the range of 0 to 5 per cent per year. Inflation rate
beyond the five per cent mark has unwanted effects on the economy. It munotes.in
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Monetary Policy
25 increases the cost of living a nd affects greatly the unorganized labor in the
country. It increases the export price and hence demand for exports fall.
During a period of rapid rise in prices, exports fall and imports rises
thereby creating balance of payments problem. It also reduces the rate of
saving because real interest rate becomes negligible to negative and real
incomes of the people are also falling. Falling saving rates and falling
demand reduces the rate of investment and economic growth. Finally,
inflation encourages unproduc tive investment in gold, real estate and the
stock markets. Prof. Chakravarty recommended a four per cent rate of
inflation as reasonable.
(C) Exchange Rate Stability
Stability in the foreign exchange rate imparts international confidence in the
value of the domestic currency and promotes a sustained growth in the
international trade. A persistent fall in the exchange rate would encourage
speculative activity in foreign exchange market and a break -down of
international confidence in the international value of a currency may also
result in the flight of foreign capital thus plunging the economy into a
currency crisis. However, to maintain exchange rate stability, internal price
stability needs to be maintained. A fall in the exchange rate is caused by
an excess demand for foreign exchange over its supply. In other words, if
demand for imports is greater than the demand for exports, the
exchange rate will rise and the international value of the domestic
currency will fall. To maintain stability in the internationa l value of
the currency, a restrictive monetary policy will have to be adopted to bring
about a reduction in money supply and the demand for imports.
In India, in the pre -reform period, the Reserve Bank of India pursued
a policy of fixed exchange rate syst em and devalued the rupee as and
when required with the permission of the IMF. But after 1991, India
adopted the floating exchange rate system. Floating exchange rate system
increases volatility and transmits its effects on the other sectors of the
economy . With a view to prevent volatility, the RBI has to take suitable
measures to maintain exchange rate stability. For instance when the rupee
depreciated against the dollar and reached a low of Rs.48 to a dollar, the
RBI took a number of measures to stop the fall of the rupee. It raised the
bank rate from 7 per cent to 8 per cent and increased the CRR from 7 to 7.5
per cent. These steps increased the lending rates and reduced the supply of
credit in the economy. Thus by increasing the cost of credit and reduc ing the
availability of credit, borrowing from the banks was discouraged with a view
to reduce the demand for dollars. Similarly, high domestic interest rates
would discourage foreign institutional investors and domestic corporate sector
to invest abroad. The reverse action is taken when the rupee
appreciates beyond reasonable limits. For instance, during 2003 -04, on
account of huge inflows of foreign exchange in India, the rupee appreciated to
43.50 in early 2004. In order to prevent the appreciation of In dian rupee,
RBI started buying US dollars from the market and stopped the appreciating munotes.in
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Macro Economics - II
26 rupee. Unwarranted appreciation and depreciation will have negative
consequences on the economy and hence Reserve Bank of India’s
intervention is necessary to manage exc hange rate stability.
(E) Equilibrium in the Balance of Payments
Exchange rate stability and equilibrium in the balance of payments are
interlinked. A country having a deficit in the balance of payments can
pursue a contractionary monetary policy and correct t he deficit in the
balance of payments. A contractionary monetary policy would reduce the
money supply in the economy and thus reduce the demand for imports.
Further fall in the money supply would also reduce domestic prices on
account of reduced domestic d emand. Lesser domestic prices will lead to
increase in the demand for exports. Finally, higher domestic interest rates
will attract foreign capital. Thus reduced demand for imports,
increased demand for exports land inflow of foreign capital will help correct
the deficit in the balance of payments and bring about equilibrium.
(F) Developing Banking & Financial Institutions
Development of Banking and Financial Institutions in a developing
country is required to encourage, mobilize and channelize savings for
capital formation. The Central Bank should also develop money and capital
markets which are required for the success of development oriented
monetary policy.
Debt management is one of the important functions of monetary policy in
a developing country. It aims at proper timing and issuing of government
bonds, stabilizing their prices and minimizing the cost of servicing the
public debt. The primary aim of debt management is to create conditions in
which public borrowing can increase from year to year. Public bor rowing is
essential in such countries in order to finance development programs and
to control money supply. Monetary policy thus helps in controlling
inflation or achieving price stability, maintaining stable exchange rates and
equilibrium in balance of pa yments, encouraging capital formation
and promoting economic growth.
3.3 INSTRUMENTS OF MONETARY POLICY
The instruments of monetary policy available at the disposal of the Central
Bank can be classified into general or quantitative instruments and selective
or qualitative instruments. The general instruments are macro -economic in
impact and are used to control the volume of credit so as to control the
inflationary and deflationary pressures caused by business cycles. The
general instruments consist of the bank rate policy, open market operations
and cash reserve ratio. The selective instruments of monetary policy are
used to regulate the use of credit and hence they are sectoral in impact.
Selective instruments therefore do not affect the entire economy. Selecti ve
instruments are used with an objective to divert the flow of credit to their
desirable and productive uses. The selective instruments consist of margin
requirements, regulation of consumer credit, use of directives, credit
rationing, moral suasion and p ublicity and direct action. munotes.in
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Monetary Policy
27 (A)Quantitative or General Instruments of Monetary Policy
1. Bank Rate or the Discount Rate Policy
Bank rate or the discount rate is the interest rate charged on borrowings made by
the commercial banks from the Central Bank. Th e Central Bank provides
financial assistance to the commercial banks by discounting eligible bills,
loans and approved securities. The objective of the bank rate policy is to
influence the cost and availability of credit to the commercial banks and the
borrowers at large in turn. The cost of credit is determined by the discount
rate or the interest rate charged and the availability of the credit is determined
by the legal requirements of making the bills eligible and the duration of
the loan. When the Centr al Bank changes the bank rate, the interest rates
in the economy also changes.
Changes in the bank rate can therefore make credit cheaper or dearer and
also influence the demand for and supply of credit. A rise in bank rate will
result in a rise in the dep osit and lending rates of banks and vice versa. A
fall in the bank rate signals an expansionary monetary policy whereas a
rise in the bank rate signals contractionary monetary policy.
The efficacy of the bank rate policy of the Central Bank is influenced b y
factors such as the development of the money market, liquidity of the
banks, business cycles, development of the bill market and the elasticity of
the economic system. If the money market where short term loans are
made available is not well organized or well developed and consist of
different rates of interest, he bank rate policy will not be effective in
influencing the varied interest rates and hence realize the objective of making
a change in the bank rate. Similarly, if the commercial banks do not approach
the Central Bank for rediscounting facility on account of surplus liquid funds,
the bank rate will fail to influence the market interest rates. Further, in order
to obtain the rediscounting facility, the commercial banks must have
sufficient quantit y of eligible bills and securities. In the absence of well
developed bill market, the bank rate policy will not have the desired effect
on the money market interest rates. In the prosperity and recessionary phases
of business cycles, investment demand is i nterest inelastic and hence changes in
the bank rate will fail to influence investment demand. During the prosperity
phase when the prices are gradually rising, profitability of investment also
rises. Thus as long as the rate of return on investment is suf ficiently greater
than the market interest rates, investment demand will continue to rise.
Similarly, during a recession, when prices are falling even if the bank rate
falls leading to fall in the market interest rates, investment demand will not
pick up b ecause of the poor prospects of making profits. Finally,
changes in the bank rate must influence interest rates, prices, costs and trade.
The economic system should be sufficiently elastic and respond to the
changes in the bank rate. Systemic rigidities wi ll not create the desired
impact.
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Macro Economics - II
28 2. Open Market Operations
Open market operations refer to buying and selling of government
securities in the open market. By doing so, the Central Bank can increase or
decrease bank reserves. When the Central Bank sells government securities in
the open market, the bank reserves fall to the extent of the sale multiplied by the
reverse credit multiplier and vice versa. The open market operation is an
important instrument of stabilization in the general price level in the hands of
the Central Bank. The Central Bank decides on its monetary policy
options given the macro -economic conditions. In an inflationary situation,
with a view to control prices, the Central Bank will decide to sell
government securities i.e., treasury bi lls which are short term government
securities and long term bonds. By doing so, the Central Bank will reduce
the bank reserves and thereby money supply will also be reduced. As a result,
the interest rates in the money market will firm up, reducing invest ment
demand. Reduction in investment demand will reduce employment, output
and incomes thus reducing the level of aggregate demand in the economy.
A reduction in the aggregate demand will help controlling the price rise.
Selling government securities throu gh the open market operation indicates
a tight or dear monetary policy. A cheap monetary policy will operate
exactly in the opposite direction when the Central Bank starts buying
government securities in a recessionary situation.
Let us see, how exactly op en market transactions in government
securities takes place when the Central Bank decides on a tight monetary
policy. The Central Bank sells government bonds or securities to dealers in
the open market. The dealers in turn, resell them to commercial banks,
corporates, financial institutions and individuals. The purchases generally
buy government securities by drawing a check in favor of the Central Bank.
For instance, if the Reserve Bank of India sells Rs.10 million worth of
treasury bills to Ms. Kareena, s he will draw a check on State Bank of India
where she has a bank account in favor of the Reserve Bank of India. The
Reserve Bank of India in turn will present the check at the State Bank of
India and when the State Bank of India pays the check, it will red uce its
balance with the Reserve Bank of India by Rs.10 million. By the end of the
day, the State Bank of India and the entire commercial banking system will
lose Rs.10 million worth of reserves at the Reserve Bank of India. Assuming
a cash reserve ratio o f ten per cent, the Rs.10 million sales of government
bonds will reduce money supply in the economy by Rs.100 million; the
reverse credit multiplier being ten. This is how the money supply contracts to
the extent of the sale multiplied by the reverse credi t multiplier.
The success of Open Market Operation depends upon a number of factors
such as development of the securities market, the rediscounting window
available at the Central bank, risk -bearing ability of the Central bank, balance
of payments, flow of capital, speculative activities etc. Nonetheless, open
market operations are known to be more effective in controlling credit.
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Monetary Policy
29 3. Cash Reserve Ratio
The Cash Reserve Ratio or the legal reserve requirements are an important
part of the mechanism by which the Central bank controls the supply of
bank money. The commercial banks are required to maintain a certain
minimum amount of non -interest -bearing reserves out of its deposits
with the Central bank. The cash reserve requirements are fixed by law
land the Central bank has the statutory powers to change the reserve
requirements. In India, the Reserve Bank of India Amendment Act, 1962
fixed reserve requirements at three per cent for all the liabilities of the
Commercial banks. The Amendment Act also gave powe rs to the Reserve
bank of India to determine reserve requirements in the range of three per
cent and 15 per cent. The Central Bank maintains a higher reserve ratio in
order to control money supply and facilitate the smooth conduct of Open
market Operations . The reserve requirements above the level that banks desire
and thereby control the short -term interest rates more effectively.
The Central bank can change cash reserve requirements in order to change the
quantity of money supply. Under inflationary condi tions, the Central bank
may follow a dear money policy and may raise the reserve requirements
within the given range of three per cent to fifteen per cent. Let us see with
an example how changes in the reserve requirements bring about changes
in the credit creating capacity of the commercial banks. Assume that the total
deposits with the commercial banks are equal to Rs.1000 billion and
the Cash Reserve Ratio is five per cent. The commercial banks will
have to maintain Rs.50 billion worth reserves with the Central Bank. The
excess reserves with the commercial banks being Rs.950 billion, the
banking system will be able to create credit twenty times its excess reserves
i.e. Rs.950 × 100 ÷ 5 = Rs.19 Trillion. Pursuing a tight or dear monetary
policy, if the Central bank decides to raise the reserve requirements to ten
per cent, then the excess reserves will be Rs.900 billion and the banking
system will be able to create only ten times its excess reserves i.e. Rs.9000
billion. Thus, when the reserve requirements are raised, the credit creating
capacity is reduced and vice -versa. However, in reality, the increase and
decrease in reserve requirements is never made on a scale as stated above
because such large changes will lead to steep fall or rise in the interest
rates. For instance, a steep hike in the Cash Reserve Ratio will lead to very
high interest rates, credit rationing, huge decline in investment and large
reduction in national income and employment. Changes in the reserve
requirements are made incrementally or marginally and in a phased manner
i.e. if the current reserve requirement is 10 per cent, with tight monetary
policy, the reserve requirement may be raised to 11 per cent and thereafter
with a gap, it may be raised by one more percentage point to 12 pe r cent.
Similarly, a cheap monetary policy would entail a marginal and phased
reduction in the Cash Reserve Ratio.
(B)Selective or Qualitative Instruments of Monetary Policy
The selective instruments of monetary policy are invoked to influence the use
and volume of credit available for particular purposes in specific sectors of
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30 various uses of credit in the various sectors so that the available credit in the
various sectors is put it its mo st desirable land productive use. Margin
requirements, consumer credit regulation, directives, credit rationing,
moral suasion and direct action are the different selective or qualitative or
specific instruments of monetary policy. These instruments are as follows.
1. Margin Requirements
Margin requirement determines the loan value of a collateral security offered
by the borrower. The loan value of a security is the difference between the
market value and the margin requirement. For instance, if the market val ue
of 10 grams of gold is Rs.12000 and the margin requirement is 25 per cent
then the loan value of 10 grams of gold as a collateral security would be
Rs.9000. Equity shares, bonds, precious metals and other financial land real
assets are accepted by comme rcial land co -operative banks as collaterals for
granting loans. The Central Bank which is the apex monetary authority in a
country has the power to determine margin requirements. Increase or
decrease in the margin requirements changes the loan value of a security.
Margin requirements are fixed differently for various types of securities. For
instance, in India margin requirements for equity shares is 50 per cent of the
market value and for commodities it various between 20 per cent and 75 per
cent. Margin requirements therefore directly influence the demand for credit
without affecting the supply of loans or the rate of interest. It is a very
instrument used to control speculative activities both in the commodity
market as well as money and the capital mark ets. For instance, the Reserve
Bank of India has greatly used the instrument of margin requirement to
check the hoarding of essential commodities and their price rise.
2. Regulation of Consumer Credit
A number of consumer durable goods such as television sets, washing
machines, refrigerators, computers, furniture, cars etc are available on
credit repayable in equated monthly installments. Consumer credit is
regulated by the Central Bank by determining the maximum period of
payment i.e. the maximum equated mont hly installments and the minimum
down payment. In order to check consumer credit, the Central bank may
increase the minimum down payment and reduce the maximum period of
payment by reducing the number of equated monthly installment.
By doing so, the Centra l bank not only increases the size of the
initial payment which is known as the minimum down payment but
also the size of the installment. Such an action by the Central bank
reduces the demand for consumer credit and thus regulates it.
3. Issue of Directives
The Central bank may direct the Commercial Banks orally or by a
written order to control the direction and volume of credit so that the
credit policy followed by the commercial banks is in harmony with
the monetary policy objectives of the Central bank. However, issue of
directives may not be effective and hence more direct instruments of
monetary policy are put into effect along with the directives. munotes.in
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Monetary Policy
31 4. Credit Rationing
Credit rationing is a qualitative instrument used to control and
regulate the purpose for w hich credit is offered by the commercial
banks. Credit rationing is carried out in two forms, namely; the
variable portfolio ceiling and the variable capital assets ratio. The
variable portfolio ceiling refers to a ceiling imposed by the Central
bank on th e total portfolios of the commercial banks. The ceiling is
imposed to ensure that loans and advances do not exceed the given
ceiling. Since the Central bank has the right to change the ceiling, it is
called variable portfolio ceiling. Similarly, the Centra l Bank may also
decide the capital assets ratio of commercial banks. These measures
restrict the loans and advances made to differentcategories of
borrowers in the economy.
5. Moral Suasion and Publicity
Moral suasion refers to formal persuasion and request made by the
Central Bank to the commercial banks. As opposed to directives, it is
an appeal made by the Central Bank to the moral consciousness of the
commercial banks to operate according to the objectives of the monetary
policy. For instance, the Central bank may request the commercial
banks to desist from financing speculative activities. It is a
psychological instrument of monetary policy. The Central bank may
also exert moral pressure on the commercial banks by going public on
the unhealthy banking pra ctices. The Reserve bank of India had used
moral suasion for the first time in September, 1949 by requesting the
commercial banks to exercise restraint in giving advances for
speculative purposes.
6. Direct Action
Direct action is a qualitative as well as a quantitative instrument of
monetary policy. The Central Bank may stop rediscounting facility to those
commercial banks whose credit policy is at divergence with its monetary
policy. It may refuse to give more credit to banks where borrowings are in
exces s of their capital and reserves. It may charge a higher rate of interest
for the credit demanded by commercial banks beyond a certain limit.
3.4 LIMITATIONS OF MONETARY POLICY
The limitations in monetary policy arise on account of the difficulties
encountered in pursuing the policy objectives in less developed countries
and on account of the inherent contradictions in the macro -economic
objectives as discussed earlier. The monetary policy over the years
has revealed the following limitations.
1. Limited in Scope:
Macro -economic policy objectives cannot be tackled and achieved only with
the help of the instruments of monetary policy. For instance, monetary
policy has practically failed in India to achieve both the objectives of price munotes.in
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32 stability and exchange rate stability. Inflation rate had been as high as
25.2 per cent in 1974 - 75. Even in the first half of the nineties, the rate
of inflation had been in double digits. While the instruments of monetary
policy may influence the aggregate demand the economy, the fail ure in
supply management will negate the very purpose of monetary policy.
Thus a combination of policies: monetary, fiscal, exchange rate and income
are needed to attack inflation.
2. Preference for Currency Money over Bank Money
In under developed economies like India, people generally prefer currency
money to bank money. Preferences for currency money is on account of lack
of banking development, ignorance about the banking procedures and
practices and wide spread illiteracy in the country. Thus an
expansion ary money policy by way of a cut in the legal reserve
requirements may not be able to realize the desired expansion in money
supply. For instance a fifty percent reduction in the legal requirements
would enhance the money supply by more than 100 per cent p rovided people
do not withdraw their deposits from the banks. The actual increase in
money supply will be reduced by the extent of deposit withdrawals. Let us
take an example. Let us assume that the excess reserve with the
commercial banks is 900 Billion a nd the cash reserve ratio is 10 percent.
The credit generated would be 900 Billion × 100 ~ 10 = 9000 Billion.
Now if the cash reserve ratio is reduced to five per cent, the credit
expansion will be 950 Billion × 100 ~ 5 = 19000 Billion. However, if people
withdraw 450 Billion from the banking system, then the expansion of credit
will be 500 Billion × 100 ~ 5 = 10,000 Billion only. In under -developed
economies like India, a major portion of the money supply is held by the
people in the form of cash and does not return to the banking system in the
form of deposits. This creates a serious limitation on the ability of the
banking system to create fresh credits on the basis of an increase in its
reserves.
3. Money Market Dualism
A contractionary monetary policy impl emented by using monetary policy
instruments such as the bank rate, the cash reserve ratio and open market
operations may not have the desired effect if the money market is not well
developed or fully integrated. While the organized money market consisting
of the commercial banks, foreign banks, co -operative banks, finance
corporations etc may operate according to the policy objectives of the Central
bank, unorganized sector consisting of the unregulated non -banking
financial intermediaries, indigenous bank ers and money lenders have no
connection with the organized sector and are legally unbound to follow the
monetary policy of the Central Bank. Further, when the sub -markets of the
money market like the treasury and the commercial bill market are not well
developed, there will be little possibility of being completely successful in
realizing the monetary policy objectives.
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Monetary Policy
33 4. Parallel Economy
When a monetary transaction is not officially recorded or reported it is
known to be a black or an illegal transaction. In under developed economies,
the size and scale of such black transactions is enormous. For instance,
the black or the parallel economy in India is estimated to be more than 50
per cent of India’s national income. Dr. Suraj Gupta of the Delhi School of
Economics conducted a study on the generation of black income and fond
that black income was 41, 45 and 50 percent of the GDP at factor cost at
current prices in the years 1980 -81, 1983 -84 and 1987 -88. In 1994 -95, the
Parliament Standing Committee estimated black money of the order of 130
percent of the GNP estimate in India. The black money in circulation
was estimated to be `.11 Trillion whereas the official GNP estimate was
`.8.43 Trillion. Under such circumstances, the monetary policy
instruments can best be described as ineffective tools of monetary
management.
5. Lack of Independence and Autonomy of the Central Bank
A Central Bank which is subservient to the policies of the government and
does not have the required autonomy and independence to decide its
monetary policy in accordance with the national economic interests cannot
imagine achieving its own policy objectives. For instance, the Federal Reserve
Bank which is the Central Bank of the United States functions as a fully
autonomous and independent gove rnment agency. It is directly responsible
to the government of the United States. However, in the event of any conflict
between her views and those that of the government, the Fed always acts in
the economic interest of the nation or in the public interest . This is because
the decisions made by the governors of the Fed are totally independent and
cannot be influenced from outside. Historical studies have proved that an
independent Central bank is more successful in controlling inflation and
thereby protecti ng the value of a nation’s currency than those Central banks
who are controlled by the executive branch of the government. The
Reserve Bank of India is not autonomous enough to pursue an
independent momentary policy. For instance, the expansion in money
supply in order to meet government’s deficit has always generated
inflationary pressures in the Indian economy and the government of India has
not allowed the Reserve bank of India to control inflation because it felt that
such an action would reduce the rat e of growth of the economy. Interest rate
administration and the supply of credit to the different sectors of the economy
had often been determined by the policy of the government than the
policies of Reserve bank of India. However, systemic limitations su ch as the
primacy of government policy over the monetary policy may vanish once the
process of converting the economy into a free market economy is complete and
the economy becomes more advanced and integrated. Monetary policy can
only be more effective in a free market economy.
6. Less Effective in Controlling Booms and Recessions
When the economy is booming with progressively higher rates of
investment, employment, output, income, demand and prices, monetary munotes.in
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Macro Economics - II
34 policy may not be very effective in controlling hi gh inflation rates particularly
when the rate of return on capital is much higher than the prevailing interest
rates. It will be quite a while before high interest rates starts affecting
investment demand and prices. It will be only in the longer run that
relatively less efficient firms starts withdrawing their investments, thus
reducing employment, income, demand and prices. Similarly, during the
period of depression, when the rate of return on investment is either uncertain
or negligibly low, investment d emand will not pick up even if the
money supply is increased and interest rates are lowered. In fact fiscal
policy is more effective in pulling an economy out of depression.
7. Lack of Control on the General Liquidity in the Economy
Reduction in money supp ly and higher interest rates are not effective enough
to reduce the aggregate demand in the economy and therefore prices
because the capacity to spend is not only determined by the money supply but
also the liquidity position of individuals and firms. The general liquidity
position is determined by factors such as cash balances, bank balance, time
and saving deposits, financial assets and the possibilities of borrowing.
Thus, a more effective way of controlling prices would be controlling the
general liquid ity in the economy.
3.5 ROLE OF MONETARY POLICY IN DEVELOPING
ECONOMIES
The monetary policy in a developing economy will have to be quite
different from that of a developed economy mainly due to different
economic conditions and requirements of the two types of economies.
A developed country may adopt full employment or price stabilization or
exchange stability as a goal of the monetary policy.
But in a developing or underdeveloped country, economic growth is the
primary and basic necessity. Thus, in a develop ing economy the monetary
policy should aim at promoting economic growth, the monetary authority
of a developing economy can play a vital role by adopting such a
monetary policy which creates conditions necessary for rapid economic
growth. Monetary policy c an serve the following developmen-tal
requirements of developing economies.
1. Developmental Role:
In a developing economy, the monetary policy can play a significant role
in accelerating economic development by influencing the supply and uses
of credit, c ontrolling inflation, and maintaining balance of payment.
Once development gains momentum, effective monetary policy can help
in meeting the requirements of expanding trade and population by
providing elastic supply of credit.
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Monetary Policy
35 2. Creation and Expansion o f Financial Institutions:
The primary aim of the monetary policy in a developing economy must be
to improve its currency and credit system. More banks and financial
institutions should be set up, particularly in those areas which lack these
facilities.
The extension of commercial banks and setting up of other financial
institutions like saving banks, cooperative saving societies, mutual
societies, etc. will help in increasing credit facilities, mobilising voluntary
savings of the people, and channelising th em into productive uses.
It is also the responsibility of the monetary authority to ensure that the
funds of the institutions are diverted into priority sectors or industries as
per requirements of are development plan of the country.
3. Effective Central Banking:
To meet the developmental needs the central bank of an underdeveloped
country must function effectively to control and regulate the volume of
credit through various monetary instruments, like bank rate, open market
operations, cash -reserve ratio e tc.
Greater and more effective credit controls will influence the allocation of
resources by diverting savings from speculative and unproductive
activities to productive uses.
4. Integration of Organised and Unorganised Money Market:
Most underdeveloped co untries are characterized by dual monetary system
in which a small but highly organised money market on the the one hand
and large but unorganised money market on the other hand operate
simultaneously.
The unorganised money market remains outside the contr ol of the central
bank. By adopting effective measures, the monetary authority should
integrate the unorganised and organised sect ors of the money market.
5. Developing Banking Habits:
The monetary authority of a less developed country should take
ap-prop riate measures to increase the proportion of bank money in the
total money supply of the country. This requires increase in the bank
deposits by developing the banking habits of the people and popularising
the use of credit instruments (e.g, cheques, draft s, etc.).
6. Monetisation of Economy:
An underdeveloped country is also marked by the existence of large non -
monetised sector. In this sector, all transactions are made through barter
system and changes in money supply and the rate of interest do not
influ ence the economic activity at all. The monetary authority should take
measures to monetise this non -monetised sector and bring it under its
control. munotes.in
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Macro Economics - II
36 7. Integrated Interest Rate Structure:
In an underdeveloped economy, there is absence of an integrated inte rest
rate structure. There is wide disparity of interest rates prevailing in the
different sectors of the economy and these rates do not respond to the
changes in the bank rate, thus making the monetary policy ineffective.
The monetary authority should tak e effective steps to integrate the interest
rate structure of the economy. Moreover, a suitable interest rate structure
should be developed which not only encourages savings and investment in
the country but also discourages speculative and unproductive lo ans.
8. Debt Management:
Debt management is another function of monetary policy in a developing
country. Debt management aims at (a) deciding proper timing and issuing
of government bonds, (b) stabilising their prices, and (c) minimising the
cost of servic ing public debt.
The monetary authority should conduct the debt management in such a
manner that conditions are created “in which public borrowing can
increase from year to year and on a big scale without giving any jolt to the
system.And this must be on c heap rates to keep the burden of the debt
low.”However, the success of debt management requires the existence of a
well- developed money and capital market along with a variety of short -
term and long -term securities.
9. Maintaining Equilibrium in Balance of Payments:
The monetary policy in a developing economy should also solve the
problem of adverse balance of payments. Such a problem generally arises
in the initial stages of economic development when the import of
machinery, raw material, etc., increase considerably, but the export may
not increase to the same extent.
The monetary authority should adopt direct foreign exchange controls and
other measures to correct the adverse balance of payments.
10. Controlling Inflationary Pressures:
Developing economi es are highly sensitive to inflationary pres-sures.
Large expenditures on developmental schemes increase aggregate
demand. But, output of consumer’s goods does not increase in the same
proportion. This leads to inflationary rise in prices.
Thus, the moneta ry policy in a developing economy should serve to
control inflationary tendencies by increasing savings by the people,
checking expansion of credit by the banking system, and discouraging
deficit financing by the government.
11. Long -Term Loans for Industr ial Development:
Monetary policy can promote industrial development in the
underdeveloped countries by promoting facilities of medium -term and munotes.in
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Monetary Policy
37 long-term loans to the manufac-turing units. The monetary authority
should induce these banks to grant long -term loans to the industrial units
by providing rediscounting facilities. Other development financial
institutions also provide long -term produc-tive loans.
12. Reforming Rural Credit System:
Rural credit system is defective and rural credit facilities are defi cient in
the underdeveloped countries. Small cultivators are poor, have no finance
of their own, and are largely dependent on loans from village money
lenders and traders who generally exploit the helplessness, ignorance and
necessity of these poor borrowe rs. The monetary authority can play an
important role in providing both short -term and long term credit to the
small arrangements, such as the establishment of cooperative credit
societies, agricultural banks etc.
3.6 SUMMARY
1. Monetary policy can be defined as a policy of the Central Bank that seeks
to influence the cost and availability of credit in an economy.
2. The broad and general objectives of monetary policy are economic
growth, full employment, price stability, exchange rate stability and
equilibrium in th e balance of payments.
3. The instruments of monetary policy available at the disposal of the
Central Bank can be classified into general or quantitative instruments
and selective or qualitative instruments.
4. The general instruments consist of the bank rate po licy, open market
operations and cash reserve ratio. The selective instruments of
monetary policy are used to regulate the use of credit and hence they are
sectoral in impact.
5. The selective instruments consist of margin requirements, regulation of
consumer credit, use of directives, credit rationing, moral suasion and
publicity and direct action.
6. The limitations in monetary policy arise on account of the difficulties
encountered in pursuing the policy objectives in less developed
countries and on account of the inherent contradictions in the
macro -economic objectives.
3.7 QUESTIONS
1. Explain the meaning and objectives of monetary policy.
2. Explain the quantitative instruments of monetary policy.
3. Explain the qualitative or selective instruments of monetary policy.
4. Explain the limitations of monetary policy.
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38
4
FISCAL POLICY
Unit Structure:
4.0 Objectives
4.1 Introduction
4.2 Meaning of Fiscal Policy
4.3 Objectives of Fiscal Policy
4.4 Instruments of Fiscal Policy
4.5 Limitations of Fiscal Policy
4.6 Role of Fiscal Policy in Developing Economies
4.7 Summary
4.8 Questions
4.0 OBJECTIVES
To under stand the meaning of Fiscal Policy.
To see the objectives of Fiscal Policy.
To study the instruments of Fiscal Policy.
To see the limitations of Fiscal Policy.
To know the role of Fiscal Policy in Developing Economies.
4.1 INTRODUCTION
The word ‘Fiscal’ is de rived from the Greek word ‘fisc’ meaning
basket. The word ‘fisc’ was used to denote the income and expenditure
operations of the government while the income generating operations relate to
taxation and government borrowing, the expenditur4e operations rela tes to
government spending. The income of the government from various sources is
called public revenue. It includes income from taxes: both direct and
indirect. Direct taxes include personal income tax, corporation tax, wealth
and gift taxes. Indirect taxe s include custom duties, excise duties and sales
tax. Taxes constitute the bulk of government incomes.
Other sources include profits generated by public sector enterprises, fines,
fees, gifts and grants. Other sources are referred to as non -tax revenue of
the government. Similarly, the government makes expenditure on various
activities which includes social and community services, economic services,
general services. It is referred to as public expenditure. Broadly speaking,
public expenditure and public re venue constitutes the tools of fiscal policy
which are at the disposal of the government to pursue its macro -economic
goals. munotes.in
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Fisca l Policy
39 Fiscal policy is the part of government policy that deals with raising
revenue through tax and non -tax sources and deciding on the level and
pattern of public expenditure.
Fiscal policy is composed of several parts. These include, tax policy,
public expenditure policy, investment or disinvestment strategies and debt
or surplus management. Fiscal policy is an important constitution of the
overall economic framework of a country and is a therefore intimately
linked with its general economic policy strategy. In most modern
economics, governments deal with fiscal policy while the central bank is
responsible for monetary policy.
These mea sures included social security expenditures and following
counter cyclical budgetary policy to keep aggregate demand high.
In developing countries, besides traditional functions, governments also
promote economic development. In developing economies, fisc al policy is
used as an important instrument to bring about creation of economic and
social infrastructure, employment generation, poverty reduction and
improvement in income distribution.
4.2 MEANING OF FISCAL POLICY
Fiscal policy can be explained as a policy executed by the government to
produce desirable effects on national income output and employment.
Prof. Ursula Hicks says that “fiscal policy is concerned with the manner
in which the different elements of public finance may collectively be
geared to for ward the aim of economic policy.” Thus for Prof. Hicks, the
objective of fiscal policy is to achieve the aim of economic policy or in
other words, the macroeconomic goals of economic growth, full employment
and price stability.
These macroeconomic goals a re more precisely brought out by the
explanation given by Prof. Paul Samuelson and Prof. William
Nordhaus. According to them, fiscal policy serves two major economic
functions, namely: (1) it sets national priorities, allocates national output
among privat e and public consumption and investment, and (2) it
provides incentives to increase or decrease output in the particular
sectors of the economy. It is through the government budget that the fiscal
policy influences the major macroeconomic goals.
Thus, Pau l and Williams define fiscal policy as “the setting of taxes and
public expenditures to help dampen the swings of business cycle and
contribute to the maintenance of a growing high employment
economy, free from high or volatile inflation.” This definition clearly
brings out the objectives of fiscal policy. When income and
expenditure as the two broad instruments of fiscal policy are used to
dampen the swings of business cycle, you are trying to achieve the goal of
price stability or economic stability. The goals of high employment rather
than full employment which are more realistic and sustained economic
growth are explicit and obvious in the definition. The governments use munotes.in
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40 budgets to plan and control their fiscal affairs. The budget shows the planned
expen diture of government programs and the expected revenues from the
tax systems. A budget surplus occurs when government income or public
revenue is greater than public expenditure. However, surplus budget has become a
thing of the past given the macroeconomi c goals of a modern State. A budget
deficit occurs when public expenditure is greater than income.
A deficit budget has become a characteristic feature of fiscal policy of all
modern governments. A balanced budget occurs when public expenditure is
equal to public revenue which is a rare possibility. When the government
has a deficit budget, it means, it is borrowing from the public by issuing
bonds which are repayable on maturity in future. The government
borrowing known as public debt consists of total or accumulated
borrowings by the government. It is the money value of government bonds
owned by the public, households, banks, businesses, foreigners and other
non-government institutions. In the Indian context, when the government
borrowing programs fails to meets its targets, the Reserve Bank of India
simply prints more notes and fills the gap between actual borrowing and
desired borrowing which is known as monetized deficit. Here precisely,
monetized deficit is the increase in the net RBI credit to the Gove rnment
of India. It consists of the net increase in the holdings of treasury bills of
the Reserve bank and its contribution to the market borrowings of the
government. It thus indicates the amount of fiscal deficit that is monetized.
Monetized deficit lead s to increase in money supply and inflation.
4.3 OBJECTIVES OF FISCAL POLICY
The fiscal policy is formulated with specific objectives in view. The
objective in developed countries is to achieve economic stability and
maintain high aggregate demand.
In developi ng countries the goal is to achieve economic growth and
development.
Following are some of the objectives of fiscal policy
1. Optimum Allocation of Resources:
The most important function of fiscal policy is to determine how the
country’s resources will be allocated. What should be the share of
different sectors of the economy in terms of resource allocation? This is
closely related to the government’s taxation and expenditure policies.
Allocation of resources depends upon the collection of taxes and size a nd
composition of government expenditure. The national budget determines
how funds are allocated to different heads of expenses. The policy of
public expenditure is used by the government to directly undertake
resource allocation for different sectors. On the other hand, the
government can use taxation and subsides to indirectly influence resource
allocation. For example, tax incentives given to SEZ units will encourage
investors to direct resources to those units.
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Fisca l Policy
41 2. Full Employment:
The importance of fis cal policy as an economic tool gained significance
during the Great Depression in 1930s when the developed countries were
suffering from unemployment. Thus the main objective of fiscal policy
was defined as achievement of full employment. For this the fisc al policy
should be designed to keep the level of aggregate demand high. In
developing economies government expenditure on social and economic
infrastructure is used to generate employment opportunities.
3. Economic Stability:
Stabilization of the economy is another important function of fiscal policy,
especially in developed economies that experience business cycles. The
cycle nature of the market in these economies causes fluctuations in
variables like income, output, investment and employment causing
hardships to the people. When growth periods end, they are followed by
contraction in the form of recession. Fiscal policy is meant to counter
these fluctuations. This known as counter cyclical fiscal policy. A counter
cyclical fiscal policy is adopted to cou nter the effects of recession and
depression by following a deficit budget. This brings about an increase in
government expenditure to generate employment and decrease in taxes to
induce consumption and investment. On the other hand, during inflation,
gove rnment expenditure and tax rates are lowered to reduce aggregate
demand and prices. A surplus budget is followed.
4. Increasing the Rate of Investment and Capital Formation:
In developing countries the problem of mass and structural
unemployment. Fiscal po licy in such countries is aimed at increasing the
rate of capital formation through investment. This can be done by giving
tax incentives and subsidies to encourage private sector investment. Also,
in many developing countries the government directly takes part in capital
formation through investment in social and economic infrastructure.
5. Encouraging Socially Optimum Pattern of Investment:
In developing countries fiscal policy can direct investment in those fields
that are most desirable from social poin t of view. For example, fiscal
incentive to small scale industries and infrastructure development.
6. Reducing Income Inequalities:
Fiscal policy can be effectively used to manipulate the distribution of
national income and resources. Taxation and public expenditure policies
are used by the government to reduce inequalities. Progressive direct taxes
impose heavier burden on the rich than the poor. Public expenditure on
social infrastructure and subsidies on food, housing, health and education
help reduce i ncome inequality.
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42 7. Reducing Unemployment and Underemployment:
Public expenditure can play an important role in this regard. Public works
programmes can be initiated to create employment and to absorb surplus
labour from areas of underemployment espec ially in developing countries.
8. Controlling Inflation:
Developing countries need to resort to deficit financing in order to finance
their programmes of industrialization and infrastructure building. This
creates inflationary conditions in the economy as purchasing power is
bound to rise with deficit financing. In order to control inflation, the ideal
fiscal response would be reduction of public expenditure. But this is
unlikely to take place in a developing country and hence the fiscal
response should be in the form of encouraging supply of goods and
services though appropriate incentives. As supply increases, the
inflationary pressure is likely to be on the decline.
4.4 INSTRUMENTS OF FISCAL POLICY
Fiscal policy is an effective instrument to control busines s fluctuations, both
recession and inflation. There are two types of fiscal policy, namely: (1)
discretionary fiscal policy and, (2) non -discretionary fiscal policy of
automatic stabilizers. Discretionary fiscal policy refers to a deliberate and
purposeful change in the government expenditure and taxes to influence the
level of national income and prices by influencing the level of aggregate
demand for goods and services. Non -discretionary fiscal policy of automatic
stabilizers refers to a built -in tax and expenditure mechanism that increases
aggregate demand when there is a recession and reduces aggregate
demand when there is inflation.
4.4.1 Discretionary Fiscal Policy
Discretionary fiscal policy is of two types, namely: (1) Anti -recessionary
fiscal policy and, (2) Anti -inflationary fiscal policy. Anti-recessionary
fiscal policy is also known as expansionary fiscal policy which is used to
draw the economy out of recession. Similarly, anti -inflationary fiscal
policy is known as contractionary fiscal policy w hich is intended to
control inflationary tendencies in the economy. An anti -inflationary fiscal
policy calls for reduction in government expenditure and raising of taxes
whereas an anti -recessionary fiscal policy calls for increase in government
expenditur e and reduction in taxes. In effect, the aim of fiscal policy is
to influence the level of aggregate demand and prices in the economy
so that the twin goals of macroeconomic management, namely:
economic growth and price stability are achieved. Fiscal polic y is
therefore a policy of demand management. An expansionary or anti -
recessionary fiscal policy would result in a deficit budget because the
government expenditure will have to be more than its income or there may
be a fall in government income on account of reduction in taxes. A
budget deficit may because either by increase in expenditure though
borrowing or by reduction in taxes and therefore tax revenue or a
combination of both these factors. The opposite will be the case of a munotes.in
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Fisca l Policy
43 contractionary or anti -inflationary fiscal policy whereby government
expenditure will be reduced and taxes raised. As a result of the reduction in
government expenditure, the budget deficit may be relatively reduced or here
may be a budget surplus.
4.4.2 Expansionary Fiscal Policy
A fall in aggregate demand due to a fall in private investment is the cause of
recession. A fall in private investment takes place because of the poor
expectations of businessmen on the profitability of investments. The fall
in aggregate demand creates deflationary gap in the economy which has to
be filled by compensatory government expenditure or by reducing taxes.
Thus, we have two methods to draw the economy out of recession, namely:
(a) compensating increase in government expenditure and, (b) reduction in
taxes.
(a) Compensating Increase in Government Expenditure:
In order to draw the economy out of recession, the government through
the technique of compensatory public spending may embark on a
massive public works program constituting social and economic
infrastructure. The construction of social and economic infrastructure
consisting of roads, national highways, dams, canals, irrigation projects,
electricity generation, schools, hospitals etc. would generate demand for
capital goods and labor. This in tur n, creates employment not only in the
capital goods industries but also in the public works program. Additional
employment will generate additional demand for consumption goods.
Thus, increase in government expenditure generates demand both for
capital and consumption goods. The incomes generated on account of
increase in government expenditure will propagate itself through the
income or the investment multiplier. The income or the investment
multiplier in turn depends upon the marginal propensity to consum e or the
marginal propensity to save. The co -efficient of the investment multiplier is
given by the formula:
Where,
‘k’ stands for the multiplier co -efficient and MPC refers to the marginal
propensity to consume.
As 1 – MPC = MPS, the multiplier formula can be restated as:
Assuming a marginal propensity to save of 20% or a marginal propensity
to consume of 80%, an additional government expenditure of Rs. One Trillion
will generate an income stream of Rs.5 Trillion through the income multiplier
process. Substituting the numerical values mentioned above in the formula, the
change in national income ( ∆Y) due to a change in investment (∆I) can munotes.in
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Macro Economics - II
44 be measured as follows:
∆Y = ∆I.K
Where,
Or
Therefore, the value of multiplier ‘k’ is 5. Thus ∆Y = Rs.1T X 5 =
Rs.5 Trillion. The size of additional government expenditure required to fill
the deflationary gap will be determined by the investment multiplier ‘k’ and
the investment multiplier in turn will be determined by the marginal
propensity to save. The effect of increase in government expenditure on
national income and employment can be illustrated with the help of
Fig.10.1 given below.
Figure 4.1
Compensatory Increase in Government Expenditure as an
Example of Anti -recessionary Fiscal Policy
Let us assume t hat the economy is operating at Y2 level of output and the
aggregate demand curve C + I2 + G2 is intersecting the 45o line at point E2.
Due to poor investment prospects, the aggregate private investment falls
leading to a fall in the aggregate demand. As a result, the aggregate
demand curve shifts downwards and to a lower level i.e. (C + I1 + G1) and
the economy shrinks to a lower equilibrium position E1 with Y1 level of
national income. The fall in national income and output will lead to open or
involuntar y unemployment and idle or excess production capacity in the
economy. The fall in investment E2F creates a deflationary gap and the
national income shrinks by Y2Y1 via the reverse multiplier, thus creating
recessionary conditions in the economy. To draw th e economy out of
recession, the government increases its expenditure ( ∆G) by E1D, munotes.in
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Fisca l Policy
45 shifting the aggregate demand curve to its original position C + I2 + G2
and national income to Y2. The increase in national income Y1Y2 is equal
to:
Where,
However, the anti -recessionary effort of the government will fully su cceed
only if the rate of interest does not rise. Due to increased government
expenditure, income and employment will rise leading to a rightward shift
in the demand for money. If the money supply remains constant, a rise in
demand for money will lead to h igher interest rates and fall in private
investment demand. The fall in private investment demand will reduce the
expansionary effect of increased government expenditure. Thus, along with
an expansionary fiscal policy, moneys supply will have to be
supplem ented by an expansionary monetary policy to keep the interest
rates constant. It only means that fiscal policy alone will not be good
enough to draw the economy out of recession. The effect of increase in
government expenditure on the transaction demand fo r money and the rate of
interest and the importance of an expansionary monetary policy to
supplement the governmental effort are shown in Fig.10.2 below.
Figure 4.2
Expansionary monetary Policy to prevent the interest rate from
rising as a result of expans ionary Fiscal Policy
It can be seen from Fig. 4.2 that the Money Demand Curve shifts towards
the right as a result of rise in income and employment. Given the
money supply curve MS1 and the new demand curve MD2, the rate of
interest will rise. However, t o keep the interest rate constant, the Central
Bank must increase money supply by MS1 – MS2. As a result of increased
money supply, the money demand curve MD2 intersects the money supply munotes.in
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Macro Economics - II
46 curve MS2 at point E2 and the rate of interest remains the same. Thus an
expansionary monetary policy supplements anti -recessionary fiscal policy
and help realize the desired impact on income and employment.
(b) Tax Reduction as an Instrument of Anti -recessionary Fiscal
Policy
Expansion in income and employment can be realize d in a recessionary
situation by reducing the tax levels. Obviously, a reduction in taxes will
increase the disposable income of the people land lead to an increase in the
aggregate demand. The possible expansion in aggregate demand as a
result of tax redu ction depends upon two objective factors, namely: the
value of tax reduction and the marginal propensity to consume. For
instance, if the net result of changes in the tax structure is a loss of revenue
to the government of the order of Rs. One Trillion and assuming the MPC to
be 80% or that the value of MPC being 0.8, consumption demand in the
economy will rise by 80,000 Crores with `..20,000 Crores as the savings made
by the community. The increase in consumption demand will have a
multiplier effect throug h the tax multiplier given by the formula:
Or
i.e.
= 1 trillion × 4 = 4 trillion
or
80000 crores ×
= 80000 crores × 5 = 4 trillion
Thus, reduction in taxes will lead to increase in consumptiondemand until the
tax multipli er process exhausts itself and in theprocess will also lead to
increase in income and employment.However, you will notice that the
expansionary effect of a policy oftax reduction is less than that of a policy of
budget deficit. In ouearlier example, the va lue of investment multiplier was 5
with MPC being 0.8, whereas the tax multiplier is only 4 with the same
MPC.
Conclusion
It is obvious from the foregoing discussion that a policy of tax reduction has a
relatively less expansionary effect on income and employment than that of a
policy of increase in government expenditure. Further, to obtain an identical
effect on income and employment by a policy of tax reduction, the budget
deficit will have to be proportionately higher than in the case of increase in
government expenditure. For instance, to bring about an identical expansion in
income and employment by way of tax reduction, the community’s disposable
income will have to be increased by Rs.1.25 Trillion ( 1.25 T × 4 = 5 T). The munotes.in
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Fisca l Policy
47 budget deficit thus will be l arger in case of adopting a policy of tax reduction.
However, the choice between the two is not all that easy. It depends upon the
relative efficiencies of the two multipliers. If it is viewed that public works
programs re relatively less efficient and tha t there will be leakage in the
governmentinitiated programs, the value of the investment multiplier will
be reduced by the extent of leakages and the delays in the execution of
public works. In that case, a policy of tax reduction will be advisable.
Howeve r, real life economics is part politics and part economics and hence
the choice between the two will depend upon politico -economic expediency.
If political expediency assumes primacy over economic expediency,
government spending will be increased because t he direct beneficiaries of
increased government expenditure are the poor and the unemployed
whereas the direct beneficiaries of tax reduction are the classes above the
middle which of course in a developing country is relatively smaller in size.
2. Anti -inflationary or Contractionary Fiscal Policy
Inflation or price rise is the result of a persistent excess aggregate demand
over aggregate supply in the economy. The rise in aggregate demand
beyond the capability of the economy during a given time to offer a
matching aggregate supply would result in price rise. The capability of the
economy is the productive capacity with the availability of the given
productive resources. If the rise in aggregate demand is on account of a large
budget deficit financed by borr owing from the Central Bank, there will be
an increase in money supply and prices would rise. Thus, along with rise in
aggregate demand, a rise in money supply would also cause the generation
of inflationary forces. On account of excess aggregate demand,
inflationary gap will be created which if not vacated or neutralized, prices
will being to rise. The fiscal policy instruments to control inflation are: (a)
reduction in government expenditure and (b) increase in taxes. Reduction in
government expenditure b y way of reduction in the budget deficit and or
by increasing the taxes, the level of aggregate demand can be brought down.
The process of decrease in government expenditure and its impact on the
level of aggregate demand is shown in Fig.8.3. The figure sh ows that the
aggregate demand curve C + I + G1 intersect the 45o line or the line of unity (
C = Y) at point ‘E1’ and determines equilibrium national income and output
at point Y1 which is the potential productive capacity of the economy during
the given t ime period. Beyond this point if the aggregate demand rises on
account of increase in government expenditure, financed by a budget
deficit, the aggregate demand curve will intersect the line of unity at point
E2. The new aggregate demand curve C + I + G2 w ill determine Y2
level of income which is greater than the productive capacity of the economy
determined at point Y1..Thus excess aggregate demand over aggregate
supply by the amount E1A shown in the figure generates an inflationary
pressure causing the prices to rise. Such a price rise or inflation is also
known as Demand -pull Inflation.
The inflationary gap can be vacated or neutralized by a decrease in the
level of aggregate demand. The level of aggregate demand can be reduced by
a contractionary fiscal policy using the fiscal policy instruments of reduced
government expenditure and increase in taxes. With equilibrium at point E2 munotes.in
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48 and money income being OY2, if the government reduces expenditure by
E2 which is equal to the inflationary gap E1A, the aggrega te demand
curve C + I + G2 will shift downward and once again the original
equilibrium level of aggregate demand C + I + G1 and Y1 level of national
income corresponding to the productive capacity of the economy will be
established. You will notice that th e fall in the nominal national income
Y2Y1 is much greater than the fall in government expenditure E2B. This is
on account of the operation of reverse income or the investment
multiplier.
Alternatively, the government can also bring about an increase in th e
direct taxes and reduce the disposable income of the community to bring
down the level of aggregate demand and prices to their desired level. In the
event that the government has a balanced budget and the economy
experiences inflationary tendencies, it w ould mean that there are supply
bottlenecks creating a shortfall in supply relative to demand. In such a
situation, an anti -inflationary or contractionary fiscal policy by way of
reduction in government expenditure will create a budget surplus. The
governm ent can vacate the budget surplus either by reducing or by
impounding public debt. However, if the bduge5t surplus is vacated by
reducing public debt, the money supply will increase and thus dampen the
anti-inflationary impact of a contractionary fiscal po licy. The best way to
realize the full impact of a contractionary fiscal policy in the event of la
budget surplus is to keep the surplus idle so that money supply does not
increase and dampen the deflationary impact of an anti -inflationary fiscal
policy.
Figure 4.3
Anti -inflationary Impact of a Contractionary Fiscal Policy
(Reduction in Government Expenditure)
Non-discretionary Fiscal Policy (Automatic Stabilizers):
The non -discretionary fiscal policy of automatic stabilizers is a built -in tax
and expendi ture mechanism that increases aggregate demand when there is munotes.in
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Fisca l Policy
49 recession and reduces aggregate demand in the event of inflation in the
economy. Thus the tax structure and the expenditure pattern vary
automatically with the changes in national income and help to maintain
economic stability. The fiscal measures of non -discretionary fiscal policy are
hence called built -in or automatic stabilizers.
The automatic fiscal stabilizing instruments are personal income tax,
corporate income tax, transfer payments and c orporate dividends.
1. Personal Income Tax and Corporate Income Tax
The personal income tax is structured in such a manner that a direct
relationship is established between tax revenue and the level of income.
Further, personal income tax is progressive in nature i.e. people in the
higher income brackets pay higher rates of tax. For instance, personal
income tax ranges between 10% minimum and 30% maximum in India.
Individuals with income above Rs.1.5 lakh but less than Rs.2.5 lakhs, the
income tax rate is 10%. BetweenRs.2.5 lakhs and Rs. Five lakhs, the
income tax rate is 20% and above Rs. Five lakhs, the marginal or the highest
rate of income tax i.e. 30% is applicable. With rise in national
income and consequent rise in personal incomes, the people will
have to pay a larger percentage of their incomes in the form of
income tax which reduces disposable incomes. Personal income tax
therefore automatically reduces the consumption demand and hence
the aggregate demand. The fall in aggregate demand checks the
inflationary tendencies in the economy. The reverse happens in the
case of fall in national income on account of recession when the
decline in the disposable income of the people is less than
proportionate to the fall in national income. However, the utility and
efficiency of personal income tax as an automatic stabilizer particularly
in the expansionary phase of a business cycle largely depends upon
the honesty of the tax payers. Similarly, taxes on corporate or
company incomes are also levied. However, in India, a flat rate of
30% corporation tax is levied unlike personal income tax which is
progressive in nature. Nonetheless, the impact of corporation tax as a
built -in automatic stabilizer of business cycle would be the same as that
of personal income tax.
2. Transfer Payments
Transfer payment is a fiscal instrument which redistributes income in
favor of the poor. For instance, unemployment allowance, subsidies
on food and inputs, and other welfare oriented programs such as free
housing for the homeless etc incr ease the level of aggregate demand
during a recession and thus reduce the impact of recession on income
and employment. Similarly, during the prosperity phase, the quantum
of transfer payments re reduced, thus reducing the level of aggregate
demand and inf lationary tendencies.
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Macro Economics - II
50 3. Corporate Dividends
The Corporate Sector follows a stable dividend policy through the
business cycles. Hence, consumption expenditure on account of
dividend receipts remains more or less table at all times. During a
recession, people who receive dividends on their equity investments
will have the same consumption expenditure as in the case of an
economic boom. Thus dividend earners will be spending
relatively more during a recession and less during the prosperity
phase. A stable divide nd policy therefore has la mitigating effect
on both inflation and recession.
Conclusion
To conclude with this section on discretionary and non -discretionary
fiscal policy, it must be stated that the success of la non-discretionary
fiscal policy of automat ic stabilizers is contingent upon a number of
uncontrollable variables such as tax compliance, honest declaration of
incomes, a stable dividend policy and more or less transparent economic
system. For instance, the parallel economy in India is conservative ly
estimated about fifty per cent of the national income and hence it will be
difficult to say that non -discretionary fiscal policy will have any significant
role in controlling business cycles. By all means, the discretionary fiscal
policy will have a dir ect and all pervasive impact on the economy and
therefore it is found to be more effective in controlling business fluctuations.
4.5 LIMITATIONS OF FISCAL POLICY
The effectiveness of fiscal policy is subject to the following limitations:
1. Practical Difficul ties:
Theoretically, the outcomes of fiscal policy are based on certain
assumptions. However, real macroeconomic situations are far more
complex. Certain assumptions made in theory may not be present in reality
making fiscal policy ineffective. For exampl e, during inflation, taxes are
raised and public expenditure is lowered. This measures would only be
effective in controlling inflation, if money supply in the economy is not
increased by government’s deficit financing. Also, fiscal policy must be
compleme ntary to monetary policy.
2. Forecasting Difficulties:
Reliable forecasting of target variables is a very important factor in the
success of fiscal measures. These variables include national income,
output, price level, employment, consumption and investm ent. Forecasting
is a function of data collection and analysis which is difficult in
developing economies. Even in developed economies, forecasting has not
been foolproof.
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Fisca l Policy
51 3. Multiplier:
The efforts of fiscal measures are transmitted to the economy throu gh the
working of various multipliers like, investment multiplier, tax multipier.
For example, the effect of an induced government investment on
infrastructure will lead to an increase in income and consumption through
the multipier process. The exact impa ct of such an investment would
depend on the investment multiplier coefficient. Firstly, it is difficult to
estimate the values of the multiplier coefficients due to leakages and
uncertainties. Secondly, there are time lags in the working of the
multiplier s. It may happen that by the time the full impact of a fiscal
decision is felt on the economy, economic conditions may have changed in
such a way that it requires another contrary fiscal decision than the
previous one. For example, the government may decid e to increase
expenditure in order to boost economic growth. This can lead to rise in
fiscal deficit. By the time economic growth is revived, the fiscal deficit
may have growth so large as to force the government cut down on capital
and revenue expenditure , once again affecting growth.
4. Time Lags:
These lags exist in case of discretionary fiscal policy which are deliberate
measures taken by the government. It takes time for the government to
recognize a problem and then decide to implement a suitable poli cy to
address the problem. These are inside lags. The outside lag is in the form
of time taken for the impact of the policy to be felt. These lags reduce the
effectiveness of fiscal policy.
5. Underdeveloped Economies:
Fiscal measures, as well as monetary policy measures, are not very
effective in underdeveloped economies due factors like, low taxable
capacity, large unorganized and non -monetised financial system, low -
income levels and corruption.
6. Political Influence:
While monetary policy is under the c entral bank’s control, fiscal policy is
implemented by the government. The central bank is an autonomous
institution, relatively free from political influence. This is not true of the
fiscal policy. The democratic governments often mix politics with
econom ics in their budget decisions. This limits the effectiveness of fiscal
policy. For example, during election years, the government may increase
subsidies and other expenditures to gain public support. This can increase
fiscal deficit and cause harm to the e conomy in the long run. Thus, short
run political gains can compromise log run economic goals of fiscal
policy.
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52 4.6 ROLE OF FISCAL POLICY IN DEVELOPING
ECONOMIES
The fiscal policy in developing countries should apparently be conducive
to rapid economic devel opment. In a poor country, fiscal policy can no
longer remain a compensatory fiscal policy. It has a tough role to play in a
developing economy and has to face the problem of growth -cum-stability.
The main goal of fiscal policy in a newly developing econom y is the
promotion of the highest possible rate of capital formation.
Underdeveloped countries are encompassed by vicious circle of poverty
on account of capital deficiency; in order to break this vicious circle, a
balanced growth is needed. It needs accel erated rate of capital formation.
Since private capital is generally shy in these countries, the government
has to fill up the lacuna. A mounting public expenditure is also required in
building social overhead capital. To accelerate the rate of capital
formation, the fiscal policy has to be designed to raise the level of
aggregate savings and to reduce the actual and potential consumption of
the people.
Another objective of fiscal policy, in a poor country is to divert existing
resources from unproductive t o productive and socially more desirable
uses. Hence, fiscal policy must be blended with planning for development.
An important aim of fiscal policy in a developing economy is to create an
equitable distribution of income and wealth in the society. Here, h owever,
a difficulty arises. The aims of rapid growth and attainment of equality in
income are two paradoxical goals because growth needs more savings and
equitable distribution causes reduction of aggregate savings as the
propensity to save of the richer section is always high and that of the poor
income group low.
As such, if high economic growth is the objective, the question arises as to
what extent inequalities should be reduced. Of course, many a time, under
the goal of socialism, the government undul y resorts to reduction of
inequalities at the cost of growth which may lead to the distribution of
poverty rather than prosperity. A reconciliation of these two contradictory
goals of growth and reduction of inequalities can definitely bring forth
better r esults.
Furthermore, fiscal policy in a poor country has an additional role of
protecting the economy from high inflation domestically and unhealthy
developments abroad. Though inflation to some extent is inevitable in the
process of growth, fiscal measure s must be designed to curb inflationary
forces. Relative price stability constitutes an important objective.
The approach to fiscal policy in an economy which is developing must be
aggregative as well as segmental. The former may lead to overall
economic e xpansion and reduce the general pressure of unemployment;
but due to the existence of bottlenecks though general price stability may
be maintained, sectoral price rise may inevitably be found. munotes.in
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Fisca l Policy
53 These sectoral imbalances are to be corrected by appropriate se gmental
fiscal measures which would remove frictions and immobility’s turn
demands into proper directions, seek to eliminate bottlenecks and other
obstacles to growth.
4.7 SUMMARY
1. Fiscal policy can be explained as a policy executed by the government to
produce desirable effects on national income output and employment.
2. The macro -economic goals of fiscal policy of all modern countries
therefore can be stated as high employment, economic growth,
economic stability land social justice and equity.
3. Fiscal policy is an effective instrument to control business fluctuations,
both recession and inflation. There are two types of fiscal policy,
namely: (1) discretionary fiscal policy and, (2) non-discretionary fiscal
policy of automatic stabilizers.
4. Discretionary fisca l policy is of two types, namely: (1) Anti -recessionary
fiscal policy and, (2) Anti -inflationary fiscal policy. Anti-recessionary
fiscal policy is also known as expansionary fiscal policy which is used
to draw the economy out of recession. Similarly, anti -inflationary fiscal
policy is known as contractionary fiscal policy which is intended to
control inflationary tendencies in the economy.
5. The fiscal measures of non -discretionary fiscal policy are hence
called built -in or automatic stabilizers. The automati c fiscal
stabilizing instruments are personal income tax, corporate income
tax, transfer payments and corporate dividends.
4.8 QUESTIONS
1. What is fiscal policy? Explain the objectives of fiscal policy.
2. Explain in detail the impact of an expansionary fiscal policy on
national income as a tool of discretionary fiscal policy.
3. Explain non -discretionary fiscal policy of automatic stabilizers.
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54 Module – III
5
IS CURVE
Unit Structure:
5.0 Objectives
5.1 Introduction
5.2 IS-LM Model of Integration of Commodity and Money Market
5.3 IS Curve
5.4 Derivation of IS Curve
5.5 Shift in IS Curve
5.6 Equilibrium in Goods Market
5.7 Summary
5.8 Questions
5.0 OBJECTIVES
To study IS -LM Mo del of Integration of Commodity and Money
Market.
To understand the derivation of IS Curve and shift in IS Curve.
To study the equilibrium in Goods Market.
5.1 IS-LM MODEL OF INTEGRATION OF
COMMODITY AND MONEY MARKET
The goods and the money markets are in terlinked by two economic
variables, namely: interest rate and national income. In this model,
interest rate is introduced in the goods market through investment demand.
The goods market therefore has two variables – interest rate (i) and
national income (GDP). The goods market equation is known as the IS
curve. The IS curve represents equality between saving (S) and investment
(I) and all points on the IS curve show goods market equilibrium at
different levels of interest and national income. The money m arket
equilibrium is determined by the demand for and supply of money at
various levels of interest and national income. The demand for money is a
function of income and interest rate. The supply of money is determined
by the Central Bank (the RBI in Indi a or the Federal Reserve in the USA).
The money market equation is known as the LM curve. The LM curve
represents equilibrium between demand and supply of money at various
levels of interest rates and national income. Various points on the LM
curve show s equality between demand for money (L) and supply of
money (M). munotes.in
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IS Curve
55 The IS -LM model shows how the equilibrium levels of income and
interest rates are simultaneously determined by the simultaneous
equilibrium in the two interdependent goods and money markets . Hicks,
Hansen and Johnson put forward the IS -LM model on the basis of
Keynesian framework of national income determination in which
investment, national income, rate of interest, demand for and supply of
money are interrelated and inter –dependent. These variables are
represented by two curves, namely; the IS and the LM curves.
5.2 THE GOODS MARKET AND THE IS CURVE
The goods market equilibrium is given by the IS schedule, which
shows the combinations of interest rates and level of output. The goods
market is in equilibrium when the supply of output is equal to aggregate
demand or when investment is equal in symbols,
Y = AD
I = S
The set of equation for equilibrium income in the Keynesian Three Sector
Model is given as below.
Y = AD ________________________ ______ (1)
Where, Y = Income/output
AD = Aggregate Demand
In Three Sector Model,
AD = C+I+G
Y=C+I+G ________________________ (2)
C = C + cYd
Where,
C = Autonomous Consumption (It is that level of consumption when level
of income is Zero)
C = Marginal prop ensity to Consume (MPC: It is the ratio of change in
consumption to change in income)
Yd = Disposable income (e.g. unemployment allowance) TR is assumed
to be constant.
The terms IS and LM are shorthand representations, respectively, of the
relationship in vestment (I) equals savings (S) – goods market equilibrium
– and money demand (L) equals money supply (M), or money market
equilibrium. The Classical article that introduced is J.R. Hicks, “Mr.
Keynes and the Classical: A Suggested Interpretations. “Econom etrical,
1937, pp. 147 -159
TR = TR
T=tY
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Macro Economics - II
56 T = Amount of tax defined as
T = Tax Rate CCcY tY TR
In Keynesian Model, I or Investment and G government demand for goods
is assumed to be constant.
i.e. II GG
Here the AD C cY tY TR I G C cY ctY cTR I G Cc T RIGc 1 – t Y
DefineA C cTR I G
At equilibrium, YA c 1 – t Y _______ _______________ (3)
Where c = MPC
t = tax Rate
Now define, C = C 1 - t YA c Y
In the above model, Investment Demand ‘I’ have treated as constant
factor.
We now introduced interest rate as a variable in the model and define
Investment D emand as a inverse function of Rate of Interest. IIb i______________________ (4)
Where, I = constant component of Investment Demand
i = rate of Interest
-b = r responsive of investment demand to change in inte rest rate, b>0
The negative sign indicate that when interest rate rises, investment
demand falls and vice -versa. Hence equation nos. 3 is written as YA c 1 – t Y - bi ____________________ (5) munotes.in
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IS Curve
57 The Keynesian model in the three sector s economy can be derived from
equation nos.5
Y-c 1-t Y= A - bi
Y[ 1-c 1-t] = A - bi
111Yct
Multiplier = 111MPC tax
Since investment is inversely related to interest r ate, a fall in the interest
rate will increase the investment demand. As a result, there will be
multiple expansions of income and output which is related to the value of
multiplier.
5.4 DERIVATION OF IS CURVE:
The IS curve is derived in the following diag ram, a fall in the interest rate.
Figure 5.1
Derivation of the IS Curve
In the upper panel of the diagram, a fall in the interest rate from 1ito1i
has caused an upward shift of the Aggregate Demand curve an d the
equilibrium income increased form 1Y to 2Y This is brought down in
the lower panel of the diagram which shows the income and interest munotes.in
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Macro Economics - II
58 relationship. In lower panel 1Yis correspon ds to higher interest rate of 1i and 2Y corresponds to 2i . The equilibrium point1E and 2E
corresponds to equilibrium points in upper panel. The IS curve connects
such points of equilibrium.
The Slope of the IS Curve:
The IS curve is steeper of flatter, according to the value of MPC and b
(investment responsiveness to change in rate of interest). This IS curve
will be flatter if the valu e of MPC and b are higher. A higher value of
MPC and lower value of rate of interest rate make the Aggregate Demand
steeper and therefore IS curve is flatter. A higher value of ‘b’cause a
greater shift in the Aggregate Demand in the upper panel and hence t he IS
curve will be flatter.
5.5 THE SHIFT IN THE IS CURVE
The shift in the IS curve is caused by an increase in autonomous
components of Aggregate Demand such as private sector investment of
government expenditure of goods and services. After holding the
interest rate constant. This is shown in following diagram.
Figure 5.2
Shift in the ISCurve
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IS Curve
59 The above diagram shows that a shift in the IS curve is caused by a change
in autonomous spending (A) or change in investment. As a resu lt, AD
curve shift up in upper panel of the diagram increasing the income and
output form 1Y to 2YThis is brought down in lower panel. At 1i we
have two income levels namely 1Y and 2Y Therefore the IS curve shift
form one levels to another.
The horizontal distance between tow IS curve is given by the value of
Multiplier (K) and size of change in investment (1). Thi s means that
higher value of Multiplier, greater will be the distance between the IS
curves.
5.6 EQUILIBRIUM IN GOODS MARKET
Equilibrium in the goods and services market occurs when the aggregate
demand for goods and services, defined as Yd = Cd + Id + G 0, is equal to
the aggregate supply of goods and services, Y.
Hence in the goods market equilibrium Yd = Y =Cd + Id + G 0. We may
express this goods market equilibrium in a different but equivalent
manner.
By subtracting Cd +G 0 from the left - and right -hand sides of the
equilibrium condition we get:
Y - Cd - G0 = Id
Using the fact that, in equilibrium, desired national saving is defined as
Sd = Y - Cd - G0 we get the equivalent equilibrium condition:
Sd = Id
Therefore, in our economy without a foreign sec tor we have equilibrium in
the market for goods and services if desired national saving is equal to
desired investment expenditure. We may represent this equilibrium
condition in a savings -investment diagram relating both desired national
saving and invest ment as functions of the real interest rate.
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60 This diagram is as below –
Figure 5.3
Equilibrium in Goods Market
In the goods market equilibrium, the desired savings and investment
graphs intersect at the interest rate r* and the desired values o f savings and
investment are equal and are also equal to the actual values of saving and
investment as recorded in the national income and product accounts.
5.7 SUMMARY
1. The IS -LM model developed in this unit is the basic model of
aggregate demand whic h integrates both the goods market and assets
market.
2. The IS curve shows combinations of interest rates and income levels
which keeps the goods market in equilibrium. Decreases in the interest
rate raise aggregate demand by raising investment expendit ure. Thus at
lower interest rate, the level of income at which the goods market is in
equilibrium is higher – the IS curve sloped downward.
3. The demand for money is a demand for real balances. The demand for
real balances increases with income and decr eases with the interest
rate, the cost of holding money rather than other assets. With an
exogenously fixed supply of real balances, the LM curve representing
money market equilibrium is upward sloping.
4. The interest rate and the level of income are jo intly determined by the
simultaneous equilibrium of the goods and money markets. This
occurs at the point of intersection of the IS and LM curves.
5. Monetary policy affects the economy initially by changing the interest
rate, and then by affecting aggre gate demand. An increase in the
money supply reduces the interest rate and increases investment
expenditure and aggregate demand thus increasing equilibrium output. munotes.in
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IS Curve
61 6. A fiscal expansion leads to increase in the interest rate which crowd
out private sect or investment. The extent of crowding out is an
important issue in assessing the usefulness and desirability of fiscal
policy as a tool of stabilization.
7. The question of the monetary -fiscal policy mix arises because
expansionary monetary policy reduces the interest rate while
expansionary fiscal policy increases the interest rate. As a result,
expansionary fiscal policy increases output while reducing the level of
investment; expansionary monetary policy increases output and the
level of investment.
5.8 QUESTIONS
1. Give note on IS -LM Model of Integration of Commodity and Money
Market.
2. Explain Derivation of IS Curve and Shift in IS Curve with the help of
diagram.
3. Explain the equilibrium in Goods Market with the help of diagram.
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62 6
LM CURVE
Unit Structure:
6.0 Objectives
6.1 Introduction to LM Curve
6.2 Derivation of LM Curve
6.3 Shift in LM Curve
6.4 Equilibrium in Money Market
6.5 Simultaneous Equilibrium in Goods and Money Market
6.6 Questions
6.0 OBJECTIVES
To know the concept LM Curve .
To understand the derivation of LM Curve .
To study of Shift in LM Curve .
To study the e quilibrium in Money Market .
To study of the si multaneous Equilibrium in Goods and Money
Market .
6.1 INTRODUCTION TO LM CURVE
Assets market is the market in which money and other interest earning
assets are traded. The total financial wealth of an individual is held in the
form of real money balanceMPand bonds. It implies that when money
market is in eq uilibrium (L = M), the bond market is also in equilibrium.
Therefore, money market equilibrium represents equilibrium of the assets
market.
The money market is in equilibrium when the demand for real balance or
liquidity preference (L) is equal to the supp ly of real money balance MP.
Here ‘M’ is supply of nominal stock of money provided by the monetary
authority and is assumed to be constant (M). The price level is also
assumed to be constant (P).
Therefore, the supply of real money balance is given as MP
Money Market Equilibrium by equation -
L = MP __________ (1) munotes.in
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LM Curve
63 Demand for money depends on level of income ‘Y’ and rate of interest ‘i’.
Therefore,
L = kY - hi __________ (2)
k > 0, h > 0
Where ,
Y = Income/Output
i = Rate of Interest
k= responsiveness of demand for money to change in income
h= responsiveness in liquidity preference to a given change in rate of
interest.
Equation no. (2) shows positive relation between ‘Y’ and ‘L’ and inverse
relation between ‘i’ and ‘L’. Equation nos. 1 can be restated as
hi = kY - MP
i = 1MkYhP __________ (3)
Equation nos. 3 shows equilibrium rate of interest.
6.2 DERIVATION OF LM CURVE
The LM schedule shows all combination of interest rate and the level of
income such that the money market is in equilibrium.
This is derived in the following diagram
Figure 6.1
Derivation of LM Curve
The LM curve in Panel ‘B’ of the diagram represents combinations of
interest rate and income, which keep the money market in equilibrium. munotes.in
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64 In Panel ‘A’ of the diagram, demand and supply of money are show. The
supply curve is vertical because both ‘M’ and ‘P’ are assumed to be
constant.
The demand curve or ‘L’ curve shift to the right along with an increase in
level of income. At 1Y level of income, the demand curve ‘L’ intersects
the supply curve at point 1E and hence the equilibri um interest in 1i.
Suppose income increases by 2Yand money demand curve shift to L’,
there is excess demand for money which raises the interest rate higher. A
new equilibrium is got at point 2E and interest rate is 2iThus money
market is found to be in equilibrium at 1Eand2E.
The combination of interest rate and income namely (1Y1i) and(2Y2i)
which maintain money market equilibrium are shown in Panel ‘B’ of the
diagram.
We get the LM curve by connecting equilibrium point 1E and 2Ein
Panel ‘B’ where income/output is measured on X – axis and interest rate is
measured on Y - axis
The Slope of the LM Curve:
The greater the responsiveness of the demand for money to income, as
measured by ‘k’, and lower the responsive of demand for money to the
interest rate as measured by ‘h’, the steeper will be the LM curve.
6.3 THE SHIFT IN THE LM CURVE:
For the given LM curve the supply of real money balance is constant. A
shift in the real money balances will shift the LM curve. An increase in the
money supply will shift t he LM curve to the right. This is because an
increase in the supply of money will reduce the equilibrium rate of
interest. This means that at the same level of income there will be lower
equilibrium point. Hence LM curve sh ift to the right.
Figure 6.2
Shift in the LM Curve
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LM Curve
65 An increase in the supply of money 1M to 2M shifts the money
supply curve to the right in Panel A of the diagram. The demand curve L
is drawn with refer ence to particular level of income. As a result of
increase in real money supply, the equilibrium interest falls from 1i to 2i.
In Panel B, we show point 1E and 2E. Thus , an increase in real money
stock shifts the LM curve to the right.
6.4 EQUILIBRIUM IN THE GOODS AND MONEY MARKET
The interaction between IS and LM curve produces a unique combination
of income and interest rate which shows simultaneous equilibr ium in the
goods and money market. This is given in diagram.
Figure 6.3
GOODS MARKET AND MONEY MARKETEQUILIBRIUM
The IS – LM intersect at point E. This point shows that at this particular
point both markets are in equilibrium with the e quilibrium level of income
as 0Yand interest rate as 0i. At point E economy is in equilibrium for a
given price level. Therefore important assumption for this analysis is that
price level remains constant.
Check your Progress:
1. Explain the slope of the LM curve.
6.5 SIMULTANEOUS EQ UILIBRIUM IN GOODS AND
MONEY MARKET
The goods and the money markets are interlinked by two economic
variables, namely: interest rate and national income. In this model, interest
rate is introduced in the goods market through investment demand. The
goods m arket therefore has two variables – interest rate (i) and national
income (GDP). The goods market equation is known as the IS curve. The IS
curve represents equality between saving (S) and investment (I) and all
points on the IS curve show goods market equ ilibrium at different levels of
interest and national income. The money market equilibrium is determined by
the demand for and supply of money at various levels of interest and national munotes.in
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66 income. The demand for money is a function of income and interest
rate. The supply of money is determined by the Central Bank (the RBI in
India or the Federal Reserve in the USA). The money market equation is
known as the LM curve. The LM curve represents equilibrium between
demand and supply of money at various levels of in terest rates and national
income. Various points on the LM curve shows equality between demand
for money (L) and supply of money (M).1
The IS -LM model shows how the equilibrium levels of income and
interest rates are simultaneously determined by the simult aneous equilibrium
in the two interdependent goods and money markets. Hicks, Hansen and
Johnson put forward the IS -LM model on the basis of Keynesian framework
of national income determination in which investment, national income, rate of
interest, demand for and supply of money are interrelated and inter –
dependent. These variables are represented by two curves, namely;
the IS and the LM curves.
The equilibrium rate of interest and the level of income is determined at the
intersection point of the IS and L M curve. The goods market is in
equilibrium at all points on the IS curve and the money market is in
equilibrium at all points on the LM curve. Hence, only at the point of
intersection between these two curves, both the money market and the
goods market wi ll be simultaneously assuming equilibrium. Such an
equilibrium condition is depicted in Fig. 6.4 below.
Figure 6.4
Simultaneous Equilibrium in the Goods and Money Market
National IncomeRate of InterestYB
C
ISDA
ELM
X Or0r1
r2
Y1 Y2 Y0
The simultaneous equilibrium in both the markets is determined at point
E, whereby r0 is the interest rate determined and Y0 is the level of national
income. At interest rate r1 and income level Y1, the goods market will be
in equilibrium at point ‘A’ on the IS curve. But at the interest rate r1, the
money market will be in equilibrium only at income level Y2 at point ‘B’ on
the LM curve. At interest rate r1, the income level Y1 is too low for money
market equilibrium and hence the money demand is not enough to match the
given quantity of money supply. With excess supply of money, interest rate
will fall until it reaches r0 level. At r0 interest rate, aggregate demand
and national income would have risen sufficiently to increase money munotes.in
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LM Curve
67 demand so that equilibrium in the two markets is obtained. Alternatively, at
r2 interest level, the income level Y2 required for goods market equilibrium
at point ‘C’ is greater than the income level Y1 required for equilibrium
in the money market at point ‘D’. With income too high for money
market equilibrium, there is excess d emand for money pushing the interest
rates up until they reach r0 with Y0 income level where both markets are in
equilibrium.
6.6 QUESTIONS
1. How LM curve is derived?
2. Show how simultaneous equilibrium is reached in goods market and
money market with the help of IS -LM curves.
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68 Module – IV
7
BALANCE OF PAYMENT
Unit Structure:
7.0 Objectives
7.1 Introduction
7.2 Structure of Balance of Payment
7.3 Types/Causes of Disequilibrium in the Balance of Payment
7.4 Measures to Correct Balance of Payment D isequilibrium
7.5 Summary
7.6 Questions
7.0 OBJECTIVES
To understand the structure of balance of payment.
To study the types or causes of disequilibrium in the balance of
payment.
To study of measures to correct the balance of payment
disequilibrium.
7.1 INTRODUCTION
A very important concept in economics is the balance of payments (BoP).
According to Kindleberger, “balance of payments is a systematic record of
all economic transactions between the residents of the reporting country
and the rest of the worl d duringgiven period of time.” In other words, a
balance of payments shows how much a country earned and how much a
country owes to the rest of the world. Any truncation that earns a foreign
exchange is known as credit transaction. Any transaction that res ults in an
outflow of foreign exchange is called a debit transaction. J. E. Meade
classified transactions of the balance of payments on the basis of the
nature of transactions. According to him, ‘an autonomous transaction’ is a
transaction that takes place for its own sack.’ That is these transactions are
entered into with the motive of satisfying some human want.
For example, an export or import because it entails utility to the producer
or consumer. Similarly, use of services gives satisfaction or helps in
production process. ‘An accommodating transaction’ refers to a
transaction undertaken with the objective or adjusting for a mismatch on
the total of autonomous transactions. For example, a country is forced to munotes.in
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69 borrow from abroad if it owns money to othe r countries as when its
imports are more than the value of its imports. An investment decision is
considered to be autonomous when it is taken with an intention to earn
profit in a country abroad. A decision to borrow abroad because the
country owes money to other country, it is considered as an
accommodating transaction since it tries to bridge the gap between
receipts and payment requirements. It is to be noted that a loan from
abroad is an accommodating transaction. However, the interest paid on
this loa n is an autonomous transaction. Based on the nature of
transactions, the balance of payments is divided into sub -accounts.
7.2 STRUCTURE OF BALANCE OF PAYMENT
The balance of payments given above is classified into subaccounts as
mentioned earlier.
1. Balance of Trade: This is the net of merchandise exports and imports.
If a country exports more than the value of goods it is importing, it is
said to be having a balance of trade surplus. Conversely, when the
country is importing more than the value of go ods exported by it, the
trade balance is said to be in deficit. Most of the countries of the world
do run deficits in their trade balance. From the above table we can see
that in 2009 -10, India had a trade deficit equal to Rs.5,60,746 crore or
U.S. $ 118,3 74 million.
2. Balance on Invisible Trade: This refers to the export and import of
services by the country. The country earns foreign exchange through
remittances by residents working abroad, providing consultancy,
tourism, providing banking, shipping and insurance services, and
interest on past loans. Conversely, a country pays foreign exchange for
imports of services, consultancy, travel abroad by residents, hiring
shipping, banking and insurance services, and by paying interest on
loans from abroad amon g others. In 2009 -10, India had a surplus on
this account equal to Rs. 3,80,120 crore, or U.S. $ 79,991 million.
3. Balance on Current Account/Current Account Balance: This is the
net of the transactions on merchandise and invisible trade. This
account is a measure of a country’s external economic health.
Persistent deficits in the current account undermine the viability of the
economy. During 2009 -10, India had a current account deficit of Rs.
1,80,626 crore or U.S. $ 38,383.
4. Balance on Capital Accoun t: This account shows the flow of finance
between the reporting country and the rest of the world. There are six
major types of transactions in this account.
Foreign capital refers to direct and portfolio investment by
individuals and corporates. An inves tment by the resident abroad is
recorded as a debit transaction as it results in an outflow of foreign
exchange. Investments made in the reporting country are recorded as
credit transactions. munotes.in
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70 Loans from Abroad refers to external commercial borrowings and
external assistance, including the trade credit accessed by exporters.
Banking capital refers to inflows and outflows in the commercial
banking sector.
Rupee Debt Servicing refers to the interest paid on loans taken from
the erstwhile Soviet Bloc countri es.
Other capital flows are miscellaneous flows India witnessed an
outflow on this account in 2009 -10.
Errors and Omissions are the sum of recording errors. For India, in
2009 -10, the sum of these six transactions amounted to Rs. 2,24,861
crore or U.S. $ 51,824 million.
5. Overall Balance: This is the net of current and capital account balance.
In 2009 -10, for India this amount was Rs. 64,235 crore, or U.S. $
13,441 million. The net inflow of capital results in reserve accretion or
addition to the stock of the foreign currency assets (FCAs) of the
country. If the country cannot mobilize adequate funds on its own, it
will have to borrow from the International Monetary Fund (IMF).
Monetary movements refer to transfer of foreign exchange
reserves/gold held b y the central bank of the country to settle the
disequilibrium in the balance of payments. If the country has a surplus
in the trade balance and/or the invisibles, it may run a surplus in the
current account. This surplus is compensated by an off -setting d eficit in
the capital account. Conversely, when the country has a deficit in the
trade balance and/or a deficit in the invisibles, it may run a deficit in the
current account. This is compensated by borrowings from other
countries, running down the reserve s, and/or a loan from the IMF. In all
such cases, the country would run a surplus in the capital account.
Thus, a country may have a deficit or a surplus in any one account but
the overall balance of payments always balances.
7.3 TYPES/CAUSES OF DISEQUIL IBRIUM IN THE
BALANCE OF PAYMENT
A balance of payments may not always be in balance. That is, at any point
of time, during a given period of time, a country may experience a
mismatch between its receipts and payments. However, a balance of
payments diseq uilibrium then has a specific connotation and should not be
confused with a temporary deviation. According to Machlup, a balance of
payments disequilibrium refers to continuous, persistent occurrence of
deficits or surpluses. Since the deficits are more co mmon and difficult to
handle, the traditional international trade theory focused on them, with
little attention to cases where there are surplus. According to
Kindleberger, there are three types of disequilibrium depending on the
nature and the underlying causes. They are classified as under:
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71 1. Cyclical Disequilibrium:
This refers to payments disequilibrium due to trade cycles. Thus, during a
boom, a country would be experiencing import surplus; exports would
decline due to higher domestic prices, and run a trade deficit. Alternately,
when there is a recession, the country would experience a surplus since the
demand for imports will decline and due to lower prices, the exports
would increase. This type of disequilibrium does not require an special
measures to contain the payments disequilibrium since the domestic
stabilisation policies would automatically take care of the disequilibrium.
When there are two countries, the country with a stronger trade cycle
would alternatively be fluctuating compared to its trading partner.
2. Secular Disequilibrium:
This case is applicable to most of the developing countries. In developing
countries, the available investment opportunities far exceed the available
savings/resources. In such cases, the country may have to bor row for a
long period until it can generate adequate exportable surpluses. As a
country develops, its production capacity increases, increases the exports
and the country earn the capacity to repay the loans. In this case, also,
there is no need for a sepa rate balance of payments adjustment policy.
3. Structural Disequilibrium:
A structural disequilibrium affects only one or few sectors of the
economy. Thus, it is different from the cyclical and secular disequilibrium,
which affect the entire economy.
Kind leberger identified two types of structural disequilibria.
A) Structural disequilibrium in the goods market: this refers to the
changes in the demand and supply conditions in a particular sector. A
sudden, permanent change in demand, like in the case ofju te industry due
to the introduction of plastic; the effect on demand for cotton textiles due
to the introduction of synthetic fibers; the impact on metal industry due to
the introduction of poly fibers, are some of the examples of structural
disequilibrium . A sudden crop failure, shortage of raw materials, a strike
in the major industry would force the country to opt for imports as in the
case of the US steel imports and cause a large deficit in the balance of
payments. Sometimes a country may suffer a loss of service income like
Egypt when the Suez Canal was closed, Belgium due to the closure of
copper mines in Congo; India in case of Gulf Crisis.
B) Structural disequilibrium in the factor markets arises when the factor
prices fails to reflect the relative factor availability. When government
tries to protect the labour and introduce wage regulations, the cost of
labour increases relative to that of the capital. In such cases, the producers
would prefer to employ more capital and less labour. As a result, th e
production structure will be distorted and the country would be producing
goods that need more of imported raw materials and a continuous munotes.in
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72 worsening of the balance of payments. In countries like India and many
other developing countries, this has happened .
C) A persistent and high rate of Inflation tends to push the relative prices
higher than the world prices. As exports become costlier, demand will
shrink. At the same time, imports would be cheaper and increasing. Thus,
the trade balance will continue t o worsen. The high rates of domestic
inflation in case of many developing countries were found to be the main
reason for decline in exports.
D) Flight of capital is also an important cause of a structural
disequilibrium. In Europe, during the 1930s, the w ithdrawal of foreign
capital lead to severe decline in the levels of output and employment and
resulted in the World War II. Similarly, in case of India, Egypt, Latin
America the political uncertainties due to independence movements led to
withdrawal of fo reign capital that permanently affected the economy. In
recent years, the fear that China may introduce communist rule in Hong
Kong led to flight of capital. A continuous depreciation in a currency also
triggers flight of capital and therefore, the central banks try to maintain a
stable exchange rate.
4. Fundamental Disequilibrium:
According to the International Monetary Fund (IMF), the case of a
‘fundamental disequilibrium’ is the most important form of disequilibrium
and needs special attention. A count ry is said to be suffering from a
fundamental disequilibrium if the following conditions are observed:
1) A persistent and high rates of domestic inflation.
2)A persistent and high levels of fiscal deficits (more than 3% of GDP).
3) An overvalued exchang e rate.
4) Factor market distortions, where the price of labour is higher thanthe
marginal product of labour and/or subsidisation of capital with the
price of capital being lower than its marginal product.
5) An irrecoverable loss of export markets due t o changes in demand or
introduction of substitutes and/or introduction of new technologies -
India loosing markets for its jute exports; Egypt loosing markets for its
cotton exports and Ghana losing its tin export markets.
6) Consistently adverse capital f lows
7) Persistent and high external borrowings, and,
8) Domestic distortions in the form of adverse trade and industrial
policies .
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73 7.4 MEASURES TO CORRECT BALANCE OF
PAYMENT DISEQUILIBRIUM
As noted earlier, though the balance of payments disequilibriu m refers to
both a deficit and a surplus, economic theory concerned it with correcting
a deficit since it is more difficult to tackle. We shall now examine some of
the methods of adjusting or overcoming a balance of payments deficit.
They are broadly class ified as monetary and non -monetary methods.
1. Monetary Measures:
These methods try to change the demand and supply of money, interest
rates, availability of credit and the exchange rates to bring about a change
in the demand for exports/imports and the s upply of exports. We shall
examine them in detail now.
A)Deflation:
Under this method, the central bank of the country with a payments deficit
will reduce the supply of credit through increase in open market
operations, reduction in money supply. The cent ral bank will reduce the
loans to the government since budget deficits are an important source of
excess demand for goods and services. It will increase the bank rate so that
the lending rates in the economy increases and this will bring down the
demand fo r bank credit. As the levels of expenditure and investment fall,
the demand for imports would decrease. At the same time, as the domestic
price level falls, the exports would become cheaper and the balance of
trade would improve. However, this method lost its sheen after the Great
Depression.
B) Depreciation:
In this case, the central bank of the country allows the market value of
exchange rate to decrease. When imports increase and exports fall, the
demand for the country’s currency decreases in the marke t and the
demand for foreign currency increases. In this case, the exchange rate
starts falling. As the exchange rate depreciates, it results in a fall in
demand for imports and exports starts picking up. However, this method is
rarely resorted to since a continuous depreciation in a currency results in
speculative attacks and this can result in flight of capital, which we
discussed in the causes of disequilibrium. It is important to remember that
since the depreciation is market determined, a currency may depreciate
visà-vis one currency and appreciate vis -à-vis another at the same time
depending on the relative demand for each currency. The 1998 Asian
Contagion is one example of speculative attacks on a currency.
C)Devaluation:
This is a method where, the central bank of the country will lower the
official value of the currency. The currency of each country is officially
declared in terms of gold or SDRs. When faced with persistent deficits,
central banks devalue their currency. Since 1946, all the member countries munotes.in
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74 of the IMF require its prior permission to devalue their currency. In June
1991, India devalued its currency in order to overcome its balance of
payments crisis. In case of devaluation, the value of the currency falls vis -
à-vis all its trading pa rtners. Thus, exports to all countries and imports
from all countries are affected equally. The use of devaluation is governed
by certain principles. This is known as the “Marshall -LernerCondition.”
Let us examine this condition first. According to this co ndition, a country
should devalue only when it faces elastic demand for both its exports and
imports. This is given as:
∂B = (Ex + Em) > 1
In the above equation, ∂B = the rate of change in the trade balance due a
devaluation. Ex = elasticity of demand for exports of the devaluing
country. Em= elasticity of demand for imports in the devaluing country. If
the sum of the elast icity is more than one, then only a country will gain
from devaluation. This is explained with the help of an example:
Suppose, India’s export elasticity is 2.1, and its import elasticity is 2.4. In
such a case, a 7.5 percent devaluation of rupee results in a 15.75 percent
increase in its exports and an 18.00 percent fall in its imports. Thus,
India’s trade balance would improve by 33.75 percent. However, using
devaluation needs caution due to the following factors:
a) Competitive Devaluation :
In this ca se, as a country tries to improve its trade balance through
devaluation, its trading partners may also try the same. In such a case, the
total trade will fall, as exports of one country are nothing but imports by
another. This has actually happened in the 1930s. It is for this reason that
the IMF ensures maintenance of stable exchange rates by all its members.
b) Nature of Trade:
Devaluation can be successful only when the country concerned
imports/exports goods that have elastic demand. In case of most of the
developing countries, their imports are of essential in nature like, oil,
fertilizers and machinery. The demand for these goods is inelastic. They
export primary goods for which the demand is either stagnant or declining.
In such cases, a devaluation of the currency may actually deteriorate the
balance of payments.
c) J-curve:
It is observed that when a country devalues its currency, the immediate
effect is a worsening of the trade balance. This is because; the demand and
supply conditions will have t o adjust to the new prices. Till such time, a
fall in the exchange rate would reduce the export earnings and the increase
in import prices will increase the import bill. It will take three months for
the trade balance to improve. During such time, the gove rnment should
not try to interfere with the working of the market. It is observed by
studies that in June 1966, when the Indian rupee was devalued, the munotes.in
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75 immediate effect was a worsening of the trade balance. Political pressures
forced the government to reve rse all the policies that were introduced to
promote trade.
d) Speculation:
It is observed that devaluation can result in further expectations about the
fall in exchange rate. Thus, the central bank has to be on guard against
such possibilities. This was t he case with many Latin American countries
in 1970s and 1980s.
C) Exchange Controls:
Under this method, the central bank tries to control the use of scarce
foreign exchange for specified purposes. It also enters into agreements
with important trading part ners about the rate at which the exports and
imports of each country need to be traded. It also determines different
exchange rates for different purposes/types of imports. Though these
methods were extensively used until recently, the IMF ensured that mos t
of them are eliminated.
2. Non -Monetary Measures: These methods try to reduce imports and/or
increase exports to improve the trade balance. The important among these
are as under:
A) Tariffs:
A tariff refers to a tax on imports and/or exports. If taxes are imposed on
exports, it is known as ‘export tariffs’ or ‘export duties’. However, export
tariffs are rare, since no country would like to see a fall in exports due to
higher prices. An ‘import tariff’ or ‘import duty’ refers to a tax on imports.
Since a tax increases the price of imports, these are popular method of
controlling imports. Further, import tariffs are an important source of
public revenue in many countries. ‘Transit duties’ are taxes imposed on
goods passing through the borders of a country, but not meant for sale in
the country. Since early 1990s, many countries have opted for
liberalization of trade and industry and as such, the role of tariffs in
adjustment has reduced greatly. Further, any discriminating tariff is
subject to the jurisdict ion of WTO and is not allowed. Thus, the role of
tariffs to improve the trade balance virtually ended in 1995.
B) Quotas:
These are restrictions on the volume of trade. They may be specified in
physical terms, as imports of a given quantity need government clearance.
They can be specified in terms of foreign exchange allowed on a particular
import. These are also redundant now since the WTO disallows are quota
restrictions on trade.
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76 7.5 SUMMARY
Balance of payments refers to the systematic records of all economic
transactions between the residents of a country and the residents of the rest
of the world. Balance of payments consists of trade account, current
account and capital account. In accounting sense balance of payments
always balances. However, in ec onomic and in real sense balances of
payments are either in surplus or in deficits. India‘s balance of payments
are in deficits since Independence. The major reasons for such as large
deficits in India‘s balance of payments are tremendous rise in import bi ll,
devaluation and depreciation of Rupee, slow rise in export earnings, stiff
competition from other emerging economies such as China, Brazil, South
Africa & even countries like Shrilanka, Bangladesh etc. The positive
aspects of recent balances of payment s in India is quite interesting.
Though the import bill is still high, the export earnings have been rising in
the country. The best method to correct the deficits in the balance of
payments is to promote and expand exports.
7.6 QUESTIONS
1. What are the various causes of balance of payments disequilibrium?
2. Examine the different monetary measures of adjustment.
3. What are the types of balance of payment disequilibrium?
4. Explain the structure of balance of payment?
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8
FOREIGN EXCHANGE MARKET
Unit Structure:
8.0 Objectives
8.1 Introduction
8.2 Foreign Exchange Market: Meaning and Nature
8.3 Determination of Exchange Rate
8.4 Fixed and Flexible Exchange Rate
8.5 Spot and Forward Exchange Rate
8.6 Exchange Rate Policy
8.7 Summary
8.8 Questions
8.0 OBJECTIVES
To know the meaning of foreign exchange market.
To study the nature of foreign exchange market.
To understand the determining process of exchange rate.
To understand the meaning of fixed and flexible exchange rate.
To understand the meanin g of spot and forward exchange rate.
To know the exchange rate policies.
8.1 INTRODUCTION
Foreign exchange market is a place (or arrangement) where the purchase
and sale of foreign exchange takes place. It is a world -wide market.
Anywhere in the world, w herever and whenever there is buying and
selling of one currency with another country‘s currency is known as
foreign exchange market. Exchange rate refers to price of a country
currency vis -à-vis another country‘s currency in other wards how many
Rupees (I ndian Currency) is equals to the value of American Dollar (US
currency). If one US $ can buy goods which forty Indian Rupee buy then
the exchange rate between US $ and Indian Rupee is 1 $ = Rupees 40.
Exchange rates are determined by the interaction of the household, firms
and financial institutions that buy and sell foreign currencies to make munotes.in
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78 international payments. The major participants in the foreign exchange
market are: (a) Commercial Banks (b) Corporations engaging in
International Trade (e) Non -Banki ng financial institutions (d) Retail –
Clients (e) Foreign Exchange Brokers and (f) Central Banks.
Exchange rate convertibility refers to the ability of residents and non -
residents to exchange domestic currency for foreign currency, without
limit, whateve r be the purpose of the transactions. In India, partial
convertibility of Rupee (j) was introduced in the Budget for 1992 -93 and
full convertibility of Rupee on Trade Account in the Budget for 1993 -94.
In August, 1994, India achieved full convertibility of rupee on current
account.
Foreign capital flows into an economy in the form of aid, borrowings,
portfolio and direct investments. Donations and grants also form a very
small portion of foreign capital inflows. Foreign Capital plays pivotal role
for the e conomic development of any country particularly a developing
economy such as India. The inflow of foreign capital in a developing
economy is associated with the inflow of foreign expertise & advanced
know how.
It is thus, interesting to clearly understand the complex nature of foreign
exchange market, players in the foreign exchange market, determination
of exchange rate factors, affecting exchange rate forms of capital Flows.
In this unit we would make an attempt to analyse these terms and their
impact on India‘s foreign trade.
8.2 FOREIGN EXCHANGE MARKET: MEANING AND
NATURE
Foreign exchange market is a place (or arrangement) where the purchase
and sale of foreign exchange takes place. It is a world -wide market.
Anywhere in the world, wherever and whenever there is buying and
selling of one currency with another country‘s currency is known as
foreign exchange market. Exchange rate refers to price of a country
currency vis -à-vis another country‘s currency in other wards how many
Rupees (Indian Currency) is e quals to the value of American Dollar (US
currency). If one US $ can buy goods which forty Indian Rupee buy then
the exchange rate between US $ and Indian Rupee is 1 $ = Rupees 40.
The economic agents involved in the forward markets can be divided into
three groups. They are: (a) Hedgers (b) Arbitrageurs & (c) Speculators.
(i) Hedgers:
These are agents (usually firms) who enter the forward exchange market
to protect themselves against the risk arising out of exchange rate
fluctuations. To understand the r isk, let us assume an Indian importer who
imports goods from U.S.A. worth $ 50,000 has to make the payments in
three months time. The spot rate at the moment is Rs. 40=$ 1 which
requires Rs. 20,00, 000. Due to uncertainty of the market, if the importer
fears a depreciation of rupee, he will have to pay more than Rs. 40/ - of munotes.in
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Foreign Exchange Market
79 rupee, $ 1 three months hence. Therefore he may enter into buying dollar
forward today, through an agreement with commercial banks or authorized
agents. If he enters into an agreement to purchase at the rate of Rs. 40.25,
he does so as he fears the depreciation of rupee. After three months he
requires to pay an additional Rs. 12,500 more. If the spot rate is more than
Rs. 40.25 after 3 months then the hedgers stand to gain. If it turns ou t to be
only Rs. 40.00 or less than that, hedgers are the losers. The advantage of
forward market which provides this facility makes the importers sure of
the money that he has to pay for obtaining $ 50,000.
(b) Arbitrageurs:
These are the agents casually banks who intends to make a riskless profit
out of discrepancies between interest rate differentials and the forward
discount and forward premium. Arbitrageurs enter into arbitrage. This
refers to purchase of an asset in a low price market and its riskles s sale in a
higher price market. This process leads to equalization of prices of an
asset in all the segments of the market. Difference in prices if at all, is not
more than transport or transaction cost.
Arbitrageurs will take advantage of the different e xchange rates prevailing
in various foreign exchange markets due to interest rate differentials. Let
us explain this with an example suppose Rs. = $ exchange rate prevailing
in India is Rs. 50= 1$ and in USA Rs. 48= 1$. People will purchase
dollars in USA and sell it in India earning a profit of Rs. 2 per dollar. In
the process increasing demand for dollars in USA will push up the prices
to Rs. 49 and more supply of dollars will bring down the price of dollar (in
India to Rs. 49. Arbitrage, therefore helps equalize the exchange rate in
different markets.
(c) Speculators:
These are agents who intend marking a profit by taking the advantage of
changes in exchange rates. They participate in the forward exchange
market by entering into forward exchange deal. Th ey do so on the basis of
their own calculation of the difference between the forward rate and the
spot rate that may prevail on a future date. For example, if a speculator
enters to sell a dollar at Rs. 41.00 after three months with expectations of
the dol lar becoming cheap and the spot rate after three months is Rs. 40 =
1 $, the speculator purchases the dollar for spot (Rs. 40) and sells for the
agreed forward rate (Rs. 41), thus making a profit of Rs. 1 per dollar. He
may incur loss if the spot rate cros ses Rs. 41.
8.3 DETERMINATION OF EXCHANGE RATE
Exchange rate in the modern days is determined by the intersection of
demand for foreign exchange (US $) and supply of foreign exchange.
1. Demand for Foreign Exchange:
Demand for foreign exchange is inversel y related with exchange rate.
Demand for foreign exchange comes mainly from importers, individuals, munotes.in
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80 institutions and government. The demand for foreign exchange is
explained with the help of following diagram.
Fig -8.1
Demand for Foreign Exchange (US Dolla rs)
In the above drawn diagram, Df represents demand for foreign exchange.
On the vertical (y) axis, exchange rate is measured and on the horizontal
(x) axis, Demand for foreign exchange is measured. Df is downward
sloping which indicates negative relation ship between exchange rate and
demand for foreign exchange. When rate of exchange falls from r0 to r1
the demand for foreign exchange increases from D0 to D1.
2. Supply of Foreign Exchange:
Supply of foreign exchange is positively related with exchange r ate.
Foreign exchange is mainly supplied by exporters, external borrowing,
earnings from foreign nationals visiting home country etc. The
relationship between exchange rate and supply of foreign exchange is
explained with the help of following diagram.
Fig -8.2 munotes.in
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Foreign Exchange Market
81 In the above drawn diagram, exchange rate is measured on Y -axis and
supply of foreign exchange on X -axis. Sf represents supply of foreign
exchange. Sf is positively sloped curve which indicates positive
relationship between exchange rate and supply of foreign exchange. When
exchange rate increases from r0 to r1, the supply of foreign exchange
increases from D0 to D1.
2 Determination of Exchange rate:
With the intersection of demand for and supply of foreign exchange, the
rate of exchange is determined. In the diagram draw below Df is demand
for foreign exchange curve and Sf represent supply of foreign exchange.
At E0, Demand for and supply of US dollar (foreign currency) is equal to
each other and r0 exchange rate is determined and D0 amount of foreign
currency is demanded and supplied.
8.4 FIXED AND FLEXIBLE EXCHANGE RATE
Foreign exchange rate is the price of one nations currency in terms of the
currency of another nation. Exchange rates are either fixed by
governments or determined by free forces of market wit h regards to
demand and supply of the same. Prior to World War II, most of the
currencies of world were convertible to gold. Later, the Bretton Woods
system came into existence wherein countries of the world pegged their
foreign exchange rate to the U.S do llar. After 1973, the Flexible exchange
rate system came into existence under which the foreign exchange rate
was influenced by the market demand and supply factors.
The two prominent exchange rate systems are Fixed exchange rate system
(Pegged system) an d Flexible exchange rate system (Fluctuating system).
The transaction in the foreign exchange market viz., buying and selling
foreign currency take at a rate, which is called „Exchange rate . This
market is not any physical place but a network of communication system
connecting the whole complex of institutions including banks, specialized
foreign exchange dealers and official government agencies through which
Fig -8. 3
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82 the currency of one country can be exchanged for that of another
(converted into another).
This is the system where the exchange rate is fixed and found rigid
irrespective of changes in the demand and supply of exchange. This rate is
fixed by the government by means of pegging operation s. (Buying and
selling exchange at a particular rate).Government follows exchange
control to keep the rates stable. It helps to reduce the exchange reserves. It
is the feature of IMF agreement.
In this system exchange rate go on fluctuating according to th e demand
and supply of it in the world market. Exchange rate is determined
according to the free forces of demand and supply of foreign currencies.
This system is quit suitable for the countries like USA. This rate is set
where the demand for exchange and supply of exchange is in equilibrium.
8.5 SPOT AND FORWARD EXCHANGE RATE
Spot rate refers to the exchange rate between two currencies that will
prevail in the market for a day or two. In other words, it is the rate for
today and tomorrow. This rate is used for settling the transactions in the
market.
Forward rate is the rate of exchange that will come into effect at a future
date. The forward rate is contracted today to settle a transaction that will
take place sometime in future. The forward rate is quoted for one, three
and six months. For example, an importer from the USA will buy dollars
today so that he will get the necessary dollars in future when he has to pay
for the imports made by him. Similarly, an exporter any sell his dollars
that will be realis ed after one month. This matching of the future demand
and supply of foreign exchange is one of the important functions of the
foreign exchange market.
The forward rate is linked to the spot rate through the interest rates and the
expectations about the f uture demand and supply of foreign exchange. Let
us assume that the spot rate between the US$ and £ is given as: US$1 =
£0.8 or £1 = US$ 1.25; and the interest rate is the US is 4 percent and in
the UK it is 4.5 percent.
The relationship between the sport rate and the forward rate is expressed
in terms of the following equation:
rf = (1 + i) r s
Where,
rf is the forward rate,
rs is the spot rate,
i is the interest rate. munotes.in
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Foreign Exchange Market
83 In the above example, the 90 -day forward rate between the US dollar and
po und woul d be: 1 (1+0.01125) = 1.264 or US$ 1 =£0.791 or US$
1.264 = £1 in other words, the country with a higher interest rate would
experience an appreciation in its exchange rate. The above condition is
known as the “interest rate parity.” That is the forward ra te of a currency
will be equal to the spot rate + the interest difference between the two
countries.
8.6 EXCHANGE RATE POLICY
The foreign exchange rate gives the price of the foreign currency in terms
of domestic currency. Under the Gold standard the exch ange rate remains
fixed and stable among the countries and the adjustments in exchange
rates are brought about by export and import of gold. The main
disadvantage of the Gold standard is that the domestic economic policies
are subject to consideration rela ting to inflow and outflow of gold. It
collapsed mainly because of the conflict between the policy prescriptions
required to meet the domestic economic situations and the requirements
necessitated by gold flows. The IMF from its inception adopted a fixed
exchange rate system which permitted changes in exchange rates only in
case of ―fundamental disequilibrium in the balance of payments.
The Bretton woods system collapsed in August, 1971 with the
abandonment of Bretton woods system, exchange rates of most of
countries have been floating. Under the floating exchange rates the
exchange rates moves up and down due to changes in demand for and
supply of currencies. The breakdown of the par value system has, in
general, encouraged countries to give more active c onsideration to the
exchange rates in domestic economic policies. Exchange rate management
plays a role complimentary to trade policy. In the first decade of the
floating exchange rate regime, serious concerns were expressed on the
volatility and misalignm ent of currencies. However, in the more recent
period there has been a general acceptance of the floating exchange rate
regime with all its short comings. Now developing countries including
India have opted for a market determined exchange rate system.
Along with the changes in exchange rate system in the world, India
exchange rate policies to change the important exchange rate policies
adopted in India are the following.
1. India’s Exchange Rate Policy Till 1991Par Value of Rupee till 1971:
Until the bre ak-down of the Bretton Woods System in August 1971, the
par value of the rupee was declared in terms of gold. The Reserve Bank of
India maintained the par value of the rupee within the permitted margin of
one percent on either side of the parity. After the devaluation of the Rupee
in 1966, the par value of the rupee was fixed at 0.118489 grams of fine
gold per rupee or Rs. 7.50 per US dollar. The RBI also kept the rupee
pound rate stable at Rs. 18 per pound sterling by its buying and selling
operations in t he foreign exchange market. Since the dollar sold rate and
pound dollar rate were maintained stable by the monetary authorities of munotes.in
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Macro Economics - II
84 U.S.A. and Britain respectively, the rupee exchange rate in terms of gold,
dollar and other countries remained stable.
2. U.S . dollar Rupee Link:
Following the suspension of convertibility of US dollar into gold in
August 1971, the government of India pegged the rupee to the U.S. dollar.
However, pound sterling contained to be used as an intervention currency.
―An intervention currency is a foreign currency, usually a reserve
currency, which the central bank of a particular country buys and sells at a
fixed exchange rate with respect to the domestic currency. The central
bank enters into open market operations in this currency to keep the
exchange rate stable vis -à-vis the domestic currency. The fluctuations in
market demand or supply of this currency d o not affect its exchange rate
because of the actions of the central bank. ―Under the system of floating,
the exchange rates of all other currencies are determined by the behaviour
of the intervention currency against those currencies.
3. Pound – Sterling Rupee Peg:
Following the Smithsonian agreement on the realignment of major
currencies in December, 1971, the U.S. dollar was devalued and other
important major currencies were revalued and the government of India
decided to peg the rupee to pound sterling . The central rupee – pound
sterling rate was fixed at Rs. 18.9677 as against the previous rate of Rs. 18
and, therefore rupee was devalued by 5.1 percent against pound – sterling.
It also continuedto be the intervention currency subsequently; British
econ omy faced a worsening of his balance of payments situation and a
down ward trend in her economic activities therefore U.K. decided to float
the pound -sterling on June 23, 1972. The exchange rate of the rupee vis -à-
vis other currencies came to be determined everyday by the previous day‘s
noon London market cross rates on June 26, 1972 to rupee was marginally
revalued by reducing the central rate to Rs. 18.9499 from Rs. 18.9677 per
pound on June 4,1972 the rupee was further revalued by 0.89 percent
when the r upee -pound sterling rate was fixed at Rs. 18.8001. This rate
remained fixed till July 2, 1975.
1. The Basket Peg:
Ever since the floating of pound sterling in June, 1972 the exchange rate
of the pound sterling witnessed a persistent down ward movement in ter ms
of US dollar. Along with it the rupee also depreciated. Since India was
under severe inflationary pressure during this period, the indirect
depreciation of the rupee helped to maintain the competitiveness of our
exports in the world market. But, by Octo ber 1974 the Wholesale Price
Index began showing a downward trend. The establishment of domestic
price stability necessitated the maintenance of stability in the external
value of the rupee. By 1975 the pound sterling depreciated significantly.
Along with the depreciation of pound -sterling the rupee also sell sharply
against all major currencies further, there was sharp fluctuations in the
exchange rates of major currencies and persistent uncertainty in the market
which raised serious doubts about the desir ability of continuing the single munotes.in
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Foreign Exchange Market
85 currency peg. Therefore in September 1975 Government of India took a
decision to delink the rupee from the pound and peg it to a basket of
selected currencies. The currencies as well as their weights in the basket
have been kept confidential by the RBI, probably to prevent speculation
against the rupee.
The changes in the rates of the rupee were determined by the changes in
the daily market value of the currency components included in the basket.
But the rate of rupee was ex pressed in terms of pound -sterling which was
continued to be the intervention currency.
The rupee -pound parity would be altered when the value of the currencies
in the basket changed by more than 2.25 percent on either side of the
prevailing central rate u ntil February 1979 and since then by 5 percent.
The change in the margin, which was necessitated by large and erratic
fluctuations in major currency notes was expected to import a measure of
stability to the exchange rate of rupee.
With the continuous flu ctuations in the exchange rates of the currencies
included in the basket the pound sterling rate was adjusted from time to
time in line with the changes in the exchange rates of currencies in the
basket for instance, the adjustment for exchange rate betwee n rupee and
pound – sterling was made on 13 February, 1989 when the middle rate
was fixed at Rs. 26.70 per pound sterling. However, the basket link has
helped to moderate the variation in the rupee rates. In order to discourage
speculation in the foreign e xchange markets on the likely changes in the
rupeesterling rate and other foreign currency rates, the actual composition
of the basket has not been disclosed.
5. Exchange Rate Policy since 1991:
Over the last few years significant changes have been brough t to bear on
the exchange rate resine as part of the overall strategy to improve the
functioning of the financial system for this purpose a devaluation of rupee
was undertaken in July 1991. Simultaneously the EXIM scrip scheme was
introduced under which ce rtain imports were permitted only against export
entitlement. The merits of scheme was that, besides providing additional
incentives to exporters through the premium on the scripts, it tried to
establish a quantitative link between imports and exports. Thi s was
followed by a dual exchange rate arrangement which entailed the
surrender of 40 percent of the exchange earnings at the official rate
facilitating import of certain commodities at the official exchange rate.
During the period of the LiberalizedExchan ge Rate Management System
(LERMS) the foreign exchange market performed well. It equilibrated 60
percent of current receipts which were realized at the market exchange
rate with a large section of imports, which had to be financed by foreign
exchange obtai ned from the market. The LERMS introduced a partial
convertibility of the rupee. In 1993 -94 Budget rupee was made fully
convertible on trade account. In august 1994 the rupee was made fully
convertible on current account. Thus in March 1993 the dual exchan ge munotes.in
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Macro Economics - II
86 rate system was dispensed with and the country moved to a single market
determined exchange rate system.
The important changes introduced in the exchange rate regime since 1991
are discussed below:
(1) Exchange Rate Adjustment of 1991:
A downward adjus tment of about 18 to 20 percent in the external value of
the Indian rupee against the major currencies was effected in two steps on
July 1 and 3, 1991.
The primary objective of the exchange rate adjustment was to strengthen
the country‘s external payments position. It was expected to provide a
reasonable incentive for export promotion and encourage efficient import
substitution activities and at the same time to stem the flight of capital
from India and discourage flow of remittances from abroad through il legal
channels.
To restore the competitiveness of our exports and bring about a reduction
in trade and current account deficits, a downward adjustment of the rupee
had become inevitable. Thus, the RBI devalued Rupee in two steps in
early July1991. On July 1, 1991 the value of the Rupee was lowered by 8
to 9 percent against the major currencies (the pound sterling, the US
dollar, the deutsche mark, the Yen and the French fane) on July 3, 1991,
the value of the Rupee was further lowered by 10 to 11 percent a gainst the
major currencies.
(ii) Liberalised Exchange Rate Management System (LERMS):
The LERMS was introduced in March 1992. It was a dual exchange rate
system. Under LERMS, 40 percent of foreign exchange earnings of
exports of goods and services are req uired to be surrendered at the official
exchange rate and the remaining 60 percent can be sold at a market
determined rate. The foreign exchange surrendered at official exchange
rate is utilized to import essential items such as petroleum, fertilizers or
life savings drugs. The foreign exchange converted at the market rate is
available to finance all other imports.
The LERMS had been introduced as a transitional arrangement towards a
unified exchange rate with current account convertibility.
8.7 SUMMARY
A well developed foreign exchange market is a pre -condition for ensuring
smooth international trade. It also helps in expanding foreign trade. The
exchange rate policy of a country must ensure the exporters and importers
that there would be more or less st ability in the exchange rate & thus less
uncertainty about fluctuations in the exchange rate. Since 1991 India has
experimented with dual exchange rate policy i.e. partly market determined
exchange rate and partly fixed exchange rate policy. However in a p hased
manner the exchange rate now is completely determined by market forces munotes.in
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Foreign Exchange Market
87 of demand & supply of foreign exchange. India has adopted full rupee
convertibility on trade account and partial rupee convertibility on capital
account. The inflows of foreign ca pital is broadly classified as portfolio
investment and foreign direct investment (as the investment of capital
inflows is concerned). Though there has been an increase in foreign
portfolio investment, the foreign direct investment has not increased as per
expectations. The prime reasons rare high transaction cost (corruption),
delay in getting clearances etc.
8.8 QUESTIONS
1. Discuss the meaning and nature of foreign exchange market.?
2. Describe India‘s exchange rate policy since 1991.
3. Explain determi nation of exchange rate.
4. Write note on –
i) Spot Exchange Rate
ii) Forward Exchange Rate
iii) Fixed Exchange Rate
iv) Flexible exchange Rate.
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