Description about the introduction of inflation and methods to contain it.Role of RBI in containing inflation.

1. What is Inflation?
 Inflation is a process in which the price
level is rising and money is losing value.
 Inflation is a rise in the price level, not in
the price of a particular commodity.
 And inflation is an ongoing process, not a
one-time jump in the price level.

2. Inflation and the Price Level
 distinction between inflation and
a one-time rise in the price
level.

3. Inflation and the Price Level
 The inflation rate is the percentage change in the
price level.
 That is, where P1 is the current price level and P0 is
last year’s price level, the inflation rate is
[(P1 – P0)/P0] × 100
 Inflation can result from either an increase in
aggregate demand or a decrease in aggregate supply
and be
 Demand-pull inflation
 Cost-push inflation

4. Demand-Pull Inflation
 Demand-pull inflation is an inflation that
results from an initial increase in aggregate
demand.
 Demand-pull inflation may begin with any
factor that increases aggregate demand.
 Two factors controlled by the government are
increases in the quantity of money and
increases in government purchases.
 A third possibility is an increase in exports.

5. Demand-Pull Inflation
 Initial Effect of an Increase in Aggregate Demand
 Starting from full employment, an increase in aggregate
demand shifts the AD curve rightward.

6. Demand-Pull Inflation
 Real GDP increases, the
price level rises, and an
inflationary gap arises.
The rising price level is the
first step in the demand-
pull inflation.

7. Demand-Pull Inflation
 The money wage rises and the SAS curve shifts leftward.
 Real GDP decreases back to potential GDP but the price level
rises further.

8. Cost-Push Inflation
 Cost-push inflation is an inflation that results
from an initial increase in costs.
 There are two main sources of increased costs:
 An increase in the money wage rate
 An increase in the money price of raw
materials, such as oil.

9. Cost-Push Inflation
 Initial Effect of a Decrease in Aggregate Supply
 A rise in the price of oil decreases short-run aggregate
supply and shifts the SAS curve leftward.

10. Cost-Push Inflation
 Real GDP decreases and the price level rises—a
combination called stagflation.
 The rising price level is the start of the cost-push
inflation.

11. Cost-Push Inflation
 Aggregate Demand Response
 The initial increase in costs creates a one-time
rise in the price level, not inflation.
 To create inflation, aggregate demand must
increase.

12. Cost-Push Inflation
 The increase in aggregate demand shifts the AD curve
rightward.
 Real GDP increases and the price level rises again.

13. Cost-Push Inflation
 If the oil producers raise the price
of oil to try to keep its relative
price higher, and the Fed responds
with an increase in aggregate
demand, a process of cost-push
inflation continues.

14. Measures to control
Inflation

15. Fiscal Measures
 Fiscal policy measures comprise the policy of the
government relating to taxation, ex­penditure and
borrowing. These three elements of fiscal policy
influence aggregate spending.
 Contractionary fiscal policy is rec­ommended during
inflation
 Often, modern governments have the tendency to spend
more to please the voters without bothering about the
impact of inflation that may fall upon the society.
 During inflation, government spending may be reduced.

16. Fiscal Measures
 Decrease in public expenditure: One of the main reasons of
inflation in excess is public expenditure like building of roads
,bridges etc. Government should drastically scale down its non
essential expenditure.
 Delay in payment of old debts: Payment of old debts that fall
due should be postponed for sometime so that people may not
acquire extra purchasing power.
 Increase in taxes :Government should levy some new direct
taxes and raise rates of old taxes.
 Over valuation of money: To control the over valuation of
money it is essential to encourage imports and
discourage exports

17. Limitations to Fiscal
Measures
 The fiscal policy and politics go hand in hand in the
sense that fiscal policy is never taken in a political
vacuum. Political compul­sions greatly reduce its
effectiveness.
 Injudicious use of tax-expenditure program may not
yield desired results.
 An increase in income tax reduces disposable income
and, hence, consumption spending. Increase in tax
rates causes rates of saving and capital for­mation to
decline.
 What is required for the effec­tiveness of these policy
measures is
good tim­ing.

18. Supply Management
Measures
 Supply side policies are government policies which seek
to increase the productivity and efficiency of the
economy thereby ,controlling inflation.
 They can involve interventionist supply side policies
(e.g. government spending on education) or free market
supply side policies (e.g. reduce government
legislation).
 To correct excess demand relative to aggregate supply,
the latter can also be raised by importing goods in short
supply.
 A reduction in company taxes to encourage greater
investment

19. Supply Management
Measures
 To increase imports of goods in short supply ,the Govern­
ment reduces customs duties on them so that their imports
become cheaper and help in containing inflation.
 At times of inflationary expectations, there is a tendency
on the part of businessmen to hoard goods for speculative
purposes. The attempt by the Government to import goods
in short supply would compel the hoarders to release their
hoarded stocks.
 A reduction in taxes which increases risk-taking and
incentives to work – a cut in income taxes can be
considered both a fiscal and a supply-side policy
 Policies to open a market to more competition to increase
supply and lower prices.

20. Monetary Policy
 Monetary policy refers to the adoption of suitable policy
regarding interest rate and the avail­ability of credit.
 It is a trade off between keeping the inflation low or
growing at faster rate.
 As an instrument of demand management, monetary
policy can work in two ways.
 Cost of Credit
 Credit Availability

21. Cost of Credit
 The higher the rate of interest, the greater the cost of
borrowing from the banks by the business firms.
 Increase in rate of interest effects short term growth of
economy.
 Repo rate is used by monetary authorities to control
inflation.
 It is the rate at which the central bank of a country
(Reserve Bank of India in case of India) lends money to
commercial banks in the event of any shortfall of funds.

23. Credit Availability
 A recent monetary theory emphasizes that it is the
changes in the credit availability rather than cost of
credit that is a more effective instrument of regulating
demand.
 By law banks have to keep a certain proportion of cash
money as reserves against their deposits. This is called
cash reserve ratio. It comes under open market
operations.
 To contract credit availability Reserve Bank can raise
this ratio.
 There are also other type of credit availability methods
like Statutory Liquid Ratio, Selective credit control.

24. Income Policy
 Another anti-inflationary measure which has often been
suggested is the avoidance of wage increases which are
unrelated to improvements in productivity.

25. Reserve Bank of India
 Reserve Bank of India or Banker’s Bank or Lender of Last Resort is the
central banking organization of India. RBI is the one who controls the
monetary policy and other financial sector of the nation. RBI was
established on 1 April 1935 by British council in according to the provisions
of the Reserve Bank of India Act, 1934. Initially the main branch of the
Reserve Bank of India established in Calcutta.
 According to Preamble of Reserve Bank of India the goals of the RBI are
described as, "...to regulate the issue of Bank Notes and keeping of reserves
with a view to securing monetary stability in India and generally to operate
the currency and credit system of the country to its advantage." India has
one of the biggest constitutions in world, and under so much law and
governance, to maintain and stabilize the financial sector with the social
equity is very difficult.

26. Function of RBI
 The RBI as a Banker’s Banker and Lender of Last Resort works as an
umbrella to the financial sector of the nation.
 For any developing country the role and functions of the central bank are
the most important for economic growth and stability. From regulating the
Banking System of the India to Debt Management of the Government, RBI
handles a vast array of responsibilities.
 Price stability, credit control, issue of the currency, managing the Foreign
Reserve, managing money supply in the financial market, etc are some of
them.
 The RBI supervises private and public banks and promotes banking in the
rural areas of the country. The Monetary Policy of RBI work to manage the
whole financial sectors in India work.

27. RBI’s role in controlling
Inflation
1. Interest rate
 Repo rate: Repo rate (Repurchase or Repossession) is the rate at which RBI
buys government securities with an agreement of repossession, from the
commercial banks. It is a short term borrowing from the central bank,
against securities, to inject money to meet the gap between the demand
for money (loans) and deposits in the bank.
 Reverse Repo rate- It is the rate at which the RBI borrows money from the
commercial banks. Banks deposit money in RBI when there is no other
profitable option to invest the short term excess liquidity or when there is
uncertainty in the market for a significant period of time
 Bank Rate- Bank rate is the rate at which the RBI allows finance to the
domestic banks. It is generally for short period of time. Unlike, Repo rate,
there are no securities to be kept against the finance. But, in policies
designed to control inflation, Bank rates are seldom revised.
 Increase in these interest rates means that the RBI is making it expensive
for the commercial banks to borrow money (in case of reverse repo rate,
lucrative to keep the deposits in RBI), thus limiting the injection of money
the market. RBI does this to decrease the liquidity in the market

28. 2. Reserve Ratio
 Cash Reserve Ratio- Banks are required to keep a fraction of deposit
liabilities in the form of liquid cash, CRR, with the RBI to ensure
safety and liquidity of the deposits.
 Statutory Liquidity Ratio:- Every bank in India has to maintain a
minimum proportion of their net demand and time deposits as liquid
assets in the form of cash, gold, precious and semiprecious stones.
SLR has nearly remained constant since last 14 years.
 If there is increase in the reserve ratios, the total amount of deposits
left with commercial banks which it can give as commercial loans
decreases and hence there is reduction in the loan granting capacity
of the banks. RBI uses this instrument for credit control in the market.

29. 3. Open Market Operations
 The RBI can purchase or sell Government securities from or to
the public. To control inflation, the RBI sells the securities in the
money market which sucks out excess liquidity from the market.
As the amount of liquid cash decreases, demand goes down. This
part of monetary policy is called the open market operation.

30. 4. Selective Credit Control
 The Banking Regulation Act empowers the RBI to control the
level and pattern of advances given by banks, selectively. The
RBI has been operating selective credit control to contain
inflation of goods that are short in supply or sensitive goods like
food grains, vegetables, pulses, oilseeds, cotton, sugar, gur,
khansari, etc which are of mass consumption. The selective
credit control policy, therefore, is to discourage advances given
by banks against these essential commodities.
 RBI uses monetary policy as a weapon to contain inflation, which
it has been religiously tightening throughout the last fiscal year
(one of its kind in the history of Indian Financial System). Surveys
(from RBI) show that the monetary tools have been successful to
combat inflation.