ABM-Module: A- MONEY SUPPLY AND INFLATION
WHAT IS MONEY
Money is anything which performs the following functions
(i) Medium of Exchange
(ii) A measure of value
(iii) A store of value over time
(iv) Standard for deferred payments
1. Medium of Exchange: Individual goods and services, and other physical assets, are 'priced' in terms of money and are exchanged using money.
2. A Measure of Value: Money is used to measure and record the value of goods or services.
3. A store of value over time: Money can be held over a period of time and used to finance future payments.
4. Standard for Deferred Payments: Money is used as an agreed measure of future receipts and payments in contracts.
MONEY SUPPLY:
1. Money supply refers to the stock of money in circulation in the economy at a given point of time.
2. This is partly exogenous (decided by the government and the central bank) and partly endogenous
Measures of Money Supply
Money stock measures were introduced by RBI during 1970 and the working group under Y B Reddy suggested major changes in the money stock measures, which gave its recommendations (during Dec 1997) and implemented during June 1998. The current measures are monetary (M) and liquidity (L) aggregates.
1. M 0: (weekly report): Currency in circulation + Bankers' deposits with RBI + Other deposits with RBI (including primary dealers' balance).
2. M 1:-(Narrow money) : fortnightly report: Currency with public + Current deposits with banking system + 15% of demand liabilities portion of saving deposits with banking system + Other deposits with RBI.
3. M 2: fortnightly report: M 1+ Time liabilities portion (i.e. remaining 85%) of saving deposits with banking system + Certificates of deposits issued by banks + Term deposits (excluding FCNR-B deposits) with a contractual maturity of up to and including one year with banking system.
4. M 3: (Broad money) fortnightly report: M 2 + Term deposits (excluding FCNR-B) with a contractual maturity of over one year with the banking system + Call borrowings from non-depository financial corporations by the banking system.
Important points regarding monetary aggregates:
1. M0 is essentially the monetary base, compiled from the balance sheet of RBI.
2. M1 purely reflects the non-interest bearing monetary liabilities of banking system.
3. M 2, besides currency and current deposits, includes saving and short term deposits reflecting the transactions balances of entities.
4. M3 has been redefined to reflect, in addition to M2, the call funding that the banking systems obtains from other financial institutions.
Liquidity Aggregates
1. L 1 = M 3 + all deposits with post office saving banks (excluding NSCs), L2 = L 1 + term deposits with term lending institutions and refinancing institutions (FIs) + term borrowin *by FIs + certificate of deposits issued by FIs and L 3 = L 2 + public deposits of NBFCs
Inflation refers to regular increase in the general price level of prices of goods and services, in an economy, over a period of time. Inflation leads to fall in purchasing power,' because with rise in price of goods and services, the same amount of money, can purchase fewer goods and services. Inflation has positive as well as negative impact on the economy. Inflation helps in bringing an economy out of recession. The negative effect is loss in real value of money.
1. Inflation refers to a sustained rise in the general level of prices of goods and services in an economy over a period of time.
2. Inflation leads to fall in purchasing power. When the price level rises, each units of currency buys fewer goods and services; consequently, inflation is also erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy.
3. Measure of price inflation is the inflation rate, i.e. the annualized percentage change in a general price index over time.
4. Inflation has both positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time, uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase further in the future. Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt.
TYPES OF INFLATION
Demand-Pull Inflation: It is rise in general prices caused by increasing aggregate demand for good and services. Increasing quantity of money in the hands of the people increases the aggregate demand for goods and services, and if aggregate supply does not follow the suit, prices rise.
Cost — Push Inflation: It is a type of inflation caused by substantial increases in the cost of production of important goods or services where no suitable alternative is available. For example, if prices of some key inputs like oil rise, producers will have to either adjust output supply or translate the higher costs into higher output prices. When output declines because
MEASURES OF INFLATION: Inflation denotes a rise in the general level of prices. The general price level is measured by a price index. A price index is a weighted average of the prices of a selected basket of goods and services relative to their prices in some designated base-year.
Calculating Inflation with Price Indexes Inflation is calculated by taking the price index of the year for which inflation is being measured and subtracting the base year from it, then dividing by the base year. This is then multiplied by 100 to give the percentage(%) change in inflation. Inflation = (Price Index in Current Year — Price Index in Base Year)/ Price Index in Base Year*100 The most important price indexes are:
(i) Wholesale Price Index (WPI)
(ii) Food Inflation Index
(iii) Consumer Price Index (CPI)
(iv) GDP deflator
Wholesale Price Index (WPI): The WPI reflects the change in the level of prices of a basket of goods at the wholesale level. WPI focuses on the price of goods traded between corporations at the wholesale stage, rather than goods bought by consumers. WPI helps to monitor price movements that reflect supply and demand in industry, manufacturing and construction sectors. It is called Headline inflation.
Food Inflation index Recently, it has been decided by government that WPI will be announced monthly. However the indices for the food group and fuel group will be announced weekly.
Consumer Price Index (CPI) The CPI reflects the change in the level of prices of a basket of goods and services purchased/consumed by the households. It measures the prices at the retail level. This is the measure of inflation more relevant for the consumers. It is the cost of living index popularly known as Core Inflation. There are four different index numbers of consumer prices. These are:
(i) CPI for industrial workers (CPI-1W)
(ii) CPI for agricultural labourers (CPI-AL)
(iii) CPI for rural workers (CPI-RW) and
(iv) CPI for urban non-manual employees (CPI-UNME).
CPI in India is released by Labour Bureau, Ministry of Labour and Employment, Government of India
GDP Deflator GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. The GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people's consumption and investment patterns.
INFLATION & RELATED ISSUES
For a common man, inflation stands for an increase in prices. To reflect the change in prices of various commodities, a price index is constructed. This index captures the overall rate of price change assigning different weights to different items.
Different price indices: There are 5 different price indices for different groups of people as different people are affected differently by the price change. These indices include wholesale price index (WPI), consumer price index for agricultural labour (CPI-AL), consumer price index for industrial workers (CPI-1W), consumer price index for urban non-manual employees (CPI-UN ME )and consumer price index for rural labour (CPIRL).
WPI measures the changes in wholesale prices. Normally, the inflation rate is expressed through wholesale price index. The change in the index for a particular week shows as to how the average level of prices of different commodities included in the WPI has changed in comparison to the corresponding week, a year ago. Whenever the rate increases it is indicator of increase in prices and whenever there is decrease, it does not necessarily mean the decrease in prices. Rather it may indicate, lower rate of increase in prices. The official inflation rate is announced in the form of WPI.
Indices for groups of consumers: WPI does not reflect the change in prices concerning a particular group of consumers. This aspect is taken care of by other indices i.e. CPI-AL, CPI-1W, CPI-UNME and CPI-RL. These indices take into account the prices of commodities, that affect the consumption pattern of a particular group.
Causes for the current inflation rate: The present high inflation rate is the result of increase in the prices of various commodities (such as pulses, fruits, vegetables, basic metal, cement, edible oils etc.). Inflation was placed at 6.73% as on Feb 03 on WPI basis. For agricultural labour (CPI-AL) was 8.93% for the same period.
Why normal prices are higher than official inflation : The price paid by the consumer for various commodities is reflected in consumer price index. The goods used by the consumers such as wheat, pulses and fruits, have higher weightage in consumer indices when compared to the WPI. In the wholesale index, the prices of all commodities are taken into account (where the weightage of individual items included in CPI is low) due to which it reflects a different price level.
Effect of inflation : Inflation affects the common man having lower purchasing power, more than the well to do persons having higher purchasing power. This reduces the real income of the consumer and the consumer is made to pay more for same quantity of goods. With an increasing inflation rate, there is increase in general interest rates on deposits/advances, which increases cost of production and sale of various goods and leads to further increase in inflation.
Inflation and money supply expansion : The money supply expansion (M3) has direct relationship with the change in inflation rate. The higher money supply expansion leads to increase in inflation rate because the liquidity fuels increase in prices of various commodities for various reasons. To control money supply expansion, RBI has to increase indicator rates such as Bank rate and Repo Rate.
How govt. and RBI control inflation : The govt. takes non-monetary initiatives relating to demand and supply side of the real market such as restriction on exports of certain commodities, liberalization of import of essential commodities by cutting down custom duties, steps to increase the production of goods and services, check hoarding etc. RBI initiates monetary measures to check inflation that include curbing the liquidity by increase in statutory reserve requirements i.e. cash reserve ratio and statutory reserve ratio that divert the use of bank deposits from loans and advances to cash and govt. securities. RBI in order to discourage banks from undertaking loans to unproductive sectors of the economy also increases the risk weightage for capital adequacy and provisioning requirements in case of standard assets for such loans.
INFLATION & RELATED TERMS
1. Inflation: A situation of a steady and sustained rise in general prices is usually known as inflation. Inflation is a state in which the value of money is falling i.e. prices are rising.
2. Cost-push Inflation: It arises due to an increase in production cost. Such type of inflation is caused by three factors: (i) an increase in wages, (ii) an increase in the profit margin and (iii) imposition of heavy taxation.
3. Demand- push Inflation: It arises as a result of strong consumer demand. When many individuals are trying to purchase the same good, the price will inevitably increase. When this happens across the entire economy for all goods, it is known as demand-pull inflation
4. Deflation: Deflation is the reverse case of inflation. Deflation is that state of falling prices which occurs at that time when the output of goods and services increases more rapidly than the volume of money in the economy. In the deflation the general price level falls and the value of money rises.
5. Disinflation: A fall in the rate of inflation. This means a slower increase in prices but not a fall in prices
6. Recession: A period of slow or negative economic growth, usually accompanied by rising unemployment.
7. Stagnation: A prolonged recession, but not as severe as a depression.
8. Disinflation: A fall in the rate of inflation. This means a slower increase in prices but not a fall in prices.
9. Depression: A prolonged recession in economic activity. The textbook definition of a recession is two consecutive quarters of declining outpur. A depression is an even deeper and more prolonged slump.
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Money is anything which performs the following functions
(i) Medium of Exchange
(ii) A measure of value
(iii) A store of value over time
(iv) Standard for deferred payments
1. Medium of Exchange: Individual goods and services, and other physical assets, are 'priced' in terms of money and are exchanged using money.
2. A Measure of Value: Money is used to measure and record the value of goods or services.
3. A store of value over time: Money can be held over a period of time and used to finance future payments.
4. Standard for Deferred Payments: Money is used as an agreed measure of future receipts and payments in contracts.
MONEY SUPPLY:
1. Money supply refers to the stock of money in circulation in the economy at a given point of time.
2. This is partly exogenous (decided by the government and the central bank) and partly endogenous
Measures of Money Supply
Money stock measures were introduced by RBI during 1970 and the working group under Y B Reddy suggested major changes in the money stock measures, which gave its recommendations (during Dec 1997) and implemented during June 1998. The current measures are monetary (M) and liquidity (L) aggregates.
1. M 0: (weekly report): Currency in circulation + Bankers' deposits with RBI + Other deposits with RBI (including primary dealers' balance).
2. M 1:-(Narrow money) : fortnightly report: Currency with public + Current deposits with banking system + 15% of demand liabilities portion of saving deposits with banking system + Other deposits with RBI.
3. M 2: fortnightly report: M 1+ Time liabilities portion (i.e. remaining 85%) of saving deposits with banking system + Certificates of deposits issued by banks + Term deposits (excluding FCNR-B deposits) with a contractual maturity of up to and including one year with banking system.
4. M 3: (Broad money) fortnightly report: M 2 + Term deposits (excluding FCNR-B) with a contractual maturity of over one year with the banking system + Call borrowings from non-depository financial corporations by the banking system.
Important points regarding monetary aggregates:
1. M0 is essentially the monetary base, compiled from the balance sheet of RBI.
2. M1 purely reflects the non-interest bearing monetary liabilities of banking system.
3. M 2, besides currency and current deposits, includes saving and short term deposits reflecting the transactions balances of entities.
4. M3 has been redefined to reflect, in addition to M2, the call funding that the banking systems obtains from other financial institutions.
Liquidity Aggregates
1. L 1 = M 3 + all deposits with post office saving banks (excluding NSCs), L2 = L 1 + term deposits with term lending institutions and refinancing institutions (FIs) + term borrowin *by FIs + certificate of deposits issued by FIs and L 3 = L 2 + public deposits of NBFCs
INFLATION
Inflation refers to regular increase in the general price level of prices of goods and services, in an economy, over a period of time. Inflation leads to fall in purchasing power,' because with rise in price of goods and services, the same amount of money, can purchase fewer goods and services. Inflation has positive as well as negative impact on the economy. Inflation helps in bringing an economy out of recession. The negative effect is loss in real value of money.
1. Inflation refers to a sustained rise in the general level of prices of goods and services in an economy over a period of time.
2. Inflation leads to fall in purchasing power. When the price level rises, each units of currency buys fewer goods and services; consequently, inflation is also erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy.
3. Measure of price inflation is the inflation rate, i.e. the annualized percentage change in a general price index over time.
4. Inflation has both positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time, uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase further in the future. Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt.
TYPES OF INFLATION
Demand-Pull Inflation: It is rise in general prices caused by increasing aggregate demand for good and services. Increasing quantity of money in the hands of the people increases the aggregate demand for goods and services, and if aggregate supply does not follow the suit, prices rise.
Cost — Push Inflation: It is a type of inflation caused by substantial increases in the cost of production of important goods or services where no suitable alternative is available. For example, if prices of some key inputs like oil rise, producers will have to either adjust output supply or translate the higher costs into higher output prices. When output declines because
MEASURES OF INFLATION: Inflation denotes a rise in the general level of prices. The general price level is measured by a price index. A price index is a weighted average of the prices of a selected basket of goods and services relative to their prices in some designated base-year.
Calculating Inflation with Price Indexes Inflation is calculated by taking the price index of the year for which inflation is being measured and subtracting the base year from it, then dividing by the base year. This is then multiplied by 100 to give the percentage(%) change in inflation. Inflation = (Price Index in Current Year — Price Index in Base Year)/ Price Index in Base Year*100 The most important price indexes are:
(i) Wholesale Price Index (WPI)
(ii) Food Inflation Index
(iii) Consumer Price Index (CPI)
(iv) GDP deflator
Wholesale Price Index (WPI): The WPI reflects the change in the level of prices of a basket of goods at the wholesale level. WPI focuses on the price of goods traded between corporations at the wholesale stage, rather than goods bought by consumers. WPI helps to monitor price movements that reflect supply and demand in industry, manufacturing and construction sectors. It is called Headline inflation.
Food Inflation index Recently, it has been decided by government that WPI will be announced monthly. However the indices for the food group and fuel group will be announced weekly.
Consumer Price Index (CPI) The CPI reflects the change in the level of prices of a basket of goods and services purchased/consumed by the households. It measures the prices at the retail level. This is the measure of inflation more relevant for the consumers. It is the cost of living index popularly known as Core Inflation. There are four different index numbers of consumer prices. These are:
(i) CPI for industrial workers (CPI-1W)
(ii) CPI for agricultural labourers (CPI-AL)
(iii) CPI for rural workers (CPI-RW) and
(iv) CPI for urban non-manual employees (CPI-UNME).
CPI in India is released by Labour Bureau, Ministry of Labour and Employment, Government of India
GDP Deflator GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. The GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people's consumption and investment patterns.
INFLATION & RELATED ISSUES
For a common man, inflation stands for an increase in prices. To reflect the change in prices of various commodities, a price index is constructed. This index captures the overall rate of price change assigning different weights to different items.
Different price indices: There are 5 different price indices for different groups of people as different people are affected differently by the price change. These indices include wholesale price index (WPI), consumer price index for agricultural labour (CPI-AL), consumer price index for industrial workers (CPI-1W), consumer price index for urban non-manual employees (CPI-UN ME )and consumer price index for rural labour (CPIRL).
WPI measures the changes in wholesale prices. Normally, the inflation rate is expressed through wholesale price index. The change in the index for a particular week shows as to how the average level of prices of different commodities included in the WPI has changed in comparison to the corresponding week, a year ago. Whenever the rate increases it is indicator of increase in prices and whenever there is decrease, it does not necessarily mean the decrease in prices. Rather it may indicate, lower rate of increase in prices. The official inflation rate is announced in the form of WPI.
Indices for groups of consumers: WPI does not reflect the change in prices concerning a particular group of consumers. This aspect is taken care of by other indices i.e. CPI-AL, CPI-1W, CPI-UNME and CPI-RL. These indices take into account the prices of commodities, that affect the consumption pattern of a particular group.
Causes for the current inflation rate: The present high inflation rate is the result of increase in the prices of various commodities (such as pulses, fruits, vegetables, basic metal, cement, edible oils etc.). Inflation was placed at 6.73% as on Feb 03 on WPI basis. For agricultural labour (CPI-AL) was 8.93% for the same period.
Why normal prices are higher than official inflation : The price paid by the consumer for various commodities is reflected in consumer price index. The goods used by the consumers such as wheat, pulses and fruits, have higher weightage in consumer indices when compared to the WPI. In the wholesale index, the prices of all commodities are taken into account (where the weightage of individual items included in CPI is low) due to which it reflects a different price level.
Effect of inflation : Inflation affects the common man having lower purchasing power, more than the well to do persons having higher purchasing power. This reduces the real income of the consumer and the consumer is made to pay more for same quantity of goods. With an increasing inflation rate, there is increase in general interest rates on deposits/advances, which increases cost of production and sale of various goods and leads to further increase in inflation.
Inflation and money supply expansion : The money supply expansion (M3) has direct relationship with the change in inflation rate. The higher money supply expansion leads to increase in inflation rate because the liquidity fuels increase in prices of various commodities for various reasons. To control money supply expansion, RBI has to increase indicator rates such as Bank rate and Repo Rate.
How govt. and RBI control inflation : The govt. takes non-monetary initiatives relating to demand and supply side of the real market such as restriction on exports of certain commodities, liberalization of import of essential commodities by cutting down custom duties, steps to increase the production of goods and services, check hoarding etc. RBI initiates monetary measures to check inflation that include curbing the liquidity by increase in statutory reserve requirements i.e. cash reserve ratio and statutory reserve ratio that divert the use of bank deposits from loans and advances to cash and govt. securities. RBI in order to discourage banks from undertaking loans to unproductive sectors of the economy also increases the risk weightage for capital adequacy and provisioning requirements in case of standard assets for such loans.
INFLATION & RELATED TERMS
1. Inflation: A situation of a steady and sustained rise in general prices is usually known as inflation. Inflation is a state in which the value of money is falling i.e. prices are rising.
2. Cost-push Inflation: It arises due to an increase in production cost. Such type of inflation is caused by three factors: (i) an increase in wages, (ii) an increase in the profit margin and (iii) imposition of heavy taxation.
3. Demand- push Inflation: It arises as a result of strong consumer demand. When many individuals are trying to purchase the same good, the price will inevitably increase. When this happens across the entire economy for all goods, it is known as demand-pull inflation
4. Deflation: Deflation is the reverse case of inflation. Deflation is that state of falling prices which occurs at that time when the output of goods and services increases more rapidly than the volume of money in the economy. In the deflation the general price level falls and the value of money rises.
5. Disinflation: A fall in the rate of inflation. This means a slower increase in prices but not a fall in prices
6. Recession: A period of slow or negative economic growth, usually accompanied by rising unemployment.
7. Stagnation: A prolonged recession, but not as severe as a depression.
8. Disinflation: A fall in the rate of inflation. This means a slower increase in prices but not a fall in prices.
9. Depression: A prolonged recession in economic activity. The textbook definition of a recession is two consecutive quarters of declining outpur. A depression is an even deeper and more prolonged slump.
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