Chapter MONEY AND INFLATION INTRODUCTION is regarded as one of the three greatest inventions of mankind; the discovery and wheel being the other two. All modern economies are money-using mies. These economies are based on specialisation and division of labour, necessitate exchange of goods and services. In these economies, goods and ices are exchanged with the use of money. In this chapter, we will study various s of money. First, we will discuss the difficulties of barter system of exchange se it is these difficulties which brought out the need for money in order to e efficient functioning of the economy. Second, we will explain the meaning ctions of money. The importance of money in a modern economy will be sed next. Money is intimately related to the price level. Therefore, we will take up for discussion various aspects of the problem of inflation. BARTER SYSTEM OF EXCHANGE ¢ the initial phase of human civilization, man had limited needs. He was nfficient. He produced everything he wanted for his living—he hunted animals Tooked for fruits for his food; he prepared his own clothes out of leaves and ‘skin and made his own dwelling for living, There was no need for exchange ‘therefore, no need for money. But with the progress of civilization, the needs of “inereased, Ik was neither feasible nor desirable for him to produce everything ranted. ‘This led to specialisation and division of labour. It was to the benefit tone to epecialise in the production of one or a few goods. Division of labour specialisation made exchange necessary. Exchange is the act of trading plus goods people have to obtain the other goods they require. 247 © scanned with OKEN Scanner= People specialised in the production of one or two commodities, produced these goods in greater quantity than what they required for their own consumption ang exchanged the surplus with other goods they required. Thus, goods had to be exchanged for goods. This was the beginning of ‘barter system of exchange’. Barter system refers to the system of exchange where goods and services are exchanged directly for other goods ang services. For example, ifa farmer produces rice in excess of his own requirements, he might exchange it for some other commodity, say cloth, which he requires hut does not produce it himself. Thus, the farmer exchanged rice for cloth produced by the weaver. Primitive exchange was carried on with the help of the barter system, Clearly money had no place in this system. Some of the traditional and tribal communities practise barter even now. The economy based upon the barter exchange is known as the barter economy. 9.2.1 Shortcomings of Barter System of Exchange The barter system suffers from various shortcomings. The main shortcomings of the barter systems are: 1. Lack of Double Coincidence of Wants: The functioning of the barter system of exchange requires what is called a ‘double coincidence of wants’, Double coincidence of wants simply means that in order to have exchange, Thave to find someone who has what I want, and that person must also want what I have. This means that persons interested in exchange must require each other's goods. In our example above, if the farmer wants to exchange rice for cloth, he must find a weaver who not only has cloth but who, at the same time, is prepared to exchange cloth for rice. In some cases where the range of goods traded is small, double coincidence of wants may easily exist, But in a large majority of cases where many goods have to be exchanged, double coineidence of wants may not exist. Barter system of exchange may turn out to be laborious, time-consuming and costly in terms of the time spent in searching for the right person and satisfactory exchange. 2. Large Number of Unnecessary Intermediate Transactions: Bartel system of exchange may give rise to a large number of unnecessary intermediate transactions when there is a lack of double coincidence of wants. The farmer, iN our example, wants to exchange rice for cloth. He may be able to find a weaver who has the cloth, but who is prepared to exchange it for utensils, Therefore, the farmer may have to exchange rice for utensils produced by the artis? (provided that the artisan wants to exchange utensils for rice), and with the a © scanned with OKEN Scanner= utensils so acquired, he would be able vorson Would have to carry through ae Ph as rice for utensils, to do the exchange inconvenient and comple pack of Common Me: ange it for cloth. Therefore, 4 number of intermediate transactions main transaction. ‘This makes the barter %, ab vals ite having a ai exchange of meet ; ow the rate at which different go ands ; ; ces _ i. be exchanged such ag how many kilograms of wheat is to je exchanged for 1 metre of cloth. In the barter syste exchange there is ; artor system of exchange no common unit in terms of which the value of all goods and services can be ceured. Hence, in the ak goods and services measul aie e absence of any common measure of value, the value of each one ity in the market has to be stated in terms of every other commodity. For example, if there are 2,000 goods in an economy, the value of each good has to be expressed in terms of 1,999 other goods. You would be surprised to know that for a small number of 2,000 goods, the number of exchange values would be 1,999,000, Such a large number of exchange rates make the functioning of an economy complicated. Indivisibility of Commodities: For an effective exchange under the barter cystem, it is essential that commodities are divisible into small quantities or parts. But there are certain commodities such as horse, TV, ete., which are not divisible. In such cases, there arises the problem when a big and indivisible commodity has to be exchanged for a small quantity of some other commodity. For example, ifa person has a horse and if he wants to exchange it for a metre of cloth, he may find it impossible to do so because he cannot divide a horse into small parts so as to exchange one small part of it with a metre of cloth. Difficulty in Store of Value: Storing of wealth becomes difficult under the barter system because of lack of a convenient medium of storing wealth. Ina barter system, people can store wealth for future use only in the form of specific commodities. But this method of storing wealth suffers from various shortcomings like cost of storage, perishable nature of some goods, etc. Difficulty Involving Future Payments: In an exchange economy, people have to en ter into contracts involving future payments such as wages, salaries, interest, rent ete. In a barter economy, these contracts about future payments have to be stated in terms of some specific commodities. This requires some commodity which is standardised with same quality of all the units and whose value does not change over time. This may be a difficult exercise. Hampers Specialisation: The extent of specialisation depends upon the case with which the surplus goods produced can be exchanged for other goods. Barter system of exchange reduces the scope of specialisation because of the difficulties of exchanging goods 45 explained above. © scanned with OKEN ScannerDifficulties of Barter System of Exchange at a Glance 1, Lack of Double Coincidence of Wants. 2. Large Number of Unnecessary Intermediate Transactions. 3. Lack of Common Measure of Value. 4. Indivisibility of Commodities. 5. Difficulty in Store of Value. 6. Difficulty involving Future Payments. 7. Hampers Specialisation. Barter system functioned reasonably well in a simple economy. It enabled people to exchange what they produced with what they required. However, with growth and expansion of the economy, many difficulties arose in using the barter system. It involved a waste of human efforts. It restricted the scope of specialisation and division of labour. It acted as an obstacle to the expansion of the economy. The difficulties of barter system became obvious with the growth of the economy. It was to overcome these difficulties of the barter system that every society invented some kind of money, 9.3 MONEY 9.3.1 Definition of Money Money is one of those concepts which is difficult to define since it is capable of being defined in different ways. In fact, money is defined differently by different economists. As Hawtrey puts it, “money is one of those concepts which, like a teaspoon or umbrella, are defined by the use or the purpose which they serve.” Conventionally, money has been defined in terms of its functions. However, different economists have given different functional definitions of money. Some of these definitions are too extensive, while others are too narrow. According to Prof. Walker, “Money is what money does”. This definition of money is very wide as well as very vague. Money performs a variety of functions, but this definition does not specify any significant function of money. ‘Then, there are some economists who defini function of money. These are stated below: Robertson defines money as “Anything which is widel i \y accepted ts for goods and in discharge of other kinds of busin See According to GDH Cole, “Me ess obligations.” resimecbed ole, “Money is anything which is habit. ‘ used as a means of pay abitually and widely aed ment and is generally accepted in the settlement of ebts. 250 ee ‘€ money in terms of one or the other © scanned with OKEN Scannero Kent, “Mones is anything which is commonly used ot ccepted as a medium of exchange or as a standard of ralue ~ sb only Je definition of money. as “anything that is generally accepted as @ means of the same time, acts as a measure and store of value” the most su ¢ definition of money for two money emphasises on all the three important functions of medium of exchange, measure of value and store of value. basic characteristic of money. namely general acceptability. ity as a means of payment or medium of exchange is the People accept money because they have the confidence be accepted by others as a means of payment. Money is accepted is accepted by others. 232 Functions of Money came into existence to overcome the difficulties of barter system of exchange. vming various functions in the economy, money has solved the difficulties banter system of exchange and has made the functioning of the economy and better. David Kinley (1861-1944) Dévid Kinley was a Scotland born economist who worked in the United States. He was professor and head of the department sfeconomics at the University of Hlinois. Later, he beeame the President of this University. As an economist, he specialised in the field of money and banking. _ Money performs several important functions. Prof. Kinley has classified the “ctions of money into three groups: (i) primary functions, (ii) secondary functions, “contingent functions. ‘ary Functions ‘hi8s category are ineluded those functions which are fundamental and essential. ‘ccey must perform these functions in every economy under all circumstances, ear ae bh © scanned with OKEN Scanneroa Primary functions of money are: : ue 1. Medium of Exchange:‘The most important function ofmoney is thatit sen... amedium of exchange. Money is generally and widely accepted as the mediyy,.. Sona de. The ot exchange with which most of the purchases or sales are mat 1€ USE of m, 8s has solved the problem of lack of double coincidence of wants by splitting exch, of goods into two parts (stages). In a modern economy, money is exchanged f, goods and services when people buy things; goods or services are exchan, for money when people sell things. The use of money as a common medium of exchange has promoted efficiency in exchange by overcoming the deficiencies. barter system. Moreover, use of money has also promoted efficiency in produetio, by encouraging specialisation and division of labour. 2. Measure of Value: The second important function of money is that it acts a, a common ‘measure of value’ or ‘unit of account’. Just as we use kilogram iy measuring the weight of a commodity, similarly for measuring the value of, commodity we take money as the unit of account. Money serves as a standar{ unit of measurement in terms of which the value of all goods and services are expressed. When we express the value of a commodity in terms of money, itis known as the price. Price is nothing but the number of units of money, say rupees, required to purchase a unit of a commodity. The use of money as: measure of value has simplified the problem of measuring the exchange values of various commodities in the market. Since the values of all the commodities are expressed in terms of money, it becomes easy to determine the rate of exchange between them by comparing their market prices. Secondary Functions Secondary functions of money are those functions which are derived from the primary functions. The following are the secondary functions of money: 1. Standard of Deferred Payment: Money acts as a standard of deferred payment. In simple terms, it means that a payment to be made in future canbe stated in terms of money. This function is an extension of medium of exchange function of money. Here again money is used as a medium of exchange, but it this case the payment is spread over a period of time, As soon as money is used as a medium of exchange and a unit of value, it is almost inevitably used asthe unit in terms of which all future or deferred payments are expressed. In amote™ economy, a large number of transactions involve payments in future such wages, salaries, interest, rent, loans, insurance premia, etc. All such transactio™ involving future payments are expressed in money terms. The reason why ths are expressed in terms of money is that money ean be ony in definite a standardised units. Thus, when we lend 210 00 expressed in " amount we would get back after one year. 3 0,000 for a year, we know the defini ut if in quantity rice, we may not be sure of getting back rice of the on § certain of the same quality after a ye" a © scanned with OKEN Scannerme eee ee of Value: Money also 7 stom ealth in the form of Le store of value, i.e. people can keeP ei bt, chere are other assets such ee ete iene No ‘sas store of val as bonds, shares, debentures, ete., which tm ‘aity. Money is a perf er store of value, particularly in one respect, je lia f perfectly liquid asset, i.c., itis a generally and readily eepted means of payment. Money allows us to store general purchasing ower which can be used any time to purchase goods and services. However, the main disadvantage of money as a store of value is that the value of money falls when the prices of goods and services rise. For instance, if the price level doubles, the value of a hundred rupee note is halved. : qransfer of Value: Money also serves as a means to transfer value. Money helps us to transfer value from one person to another. For example, when we puya pen from the shopkeeper for 220, we are thereby transferring value equal {o%20 to the shopkeeper, and he can use it to purchase other goods. Similarly, money is a quick and efficient means of transferring value from one place to another. We may sell a house in Delhi in exchange for money and can use the same money in buying a house in Kolkata. Contingent Functions of Money Contingent functions refer to the use of money in assisting various economic entities auth as consumers, producers, etc. in making decisions related to consumption, moduction, etc. The main contingent functions are as follows: L Maximisation of Utility: A rational consumer wants to maximise his utility while purchasing various goods and services. The consumer will be able to maximise his total utility if the ratios of the marginal utilities of different commodities are equal to the ratio of their prices. For equalising the ratios of marginal utilities, money plays.an important part because the prices of all commodities are expressed in terms of money. Employment of Factor Inputs: Every producer aims to maximise his factors of production, A profit-maximising profit while employing various pr » entrepreneur will equate marginal productivity (expressed in value terms) of a factor with the remuneration to be paid for various factor services such as Wage rate, rate of interest, ete. Since rates of remuneration Ere expressed in money terms, it is money which helps the producer in arriving at decisions with regard fo the units of a factor of production t0 be employed by him. Distrihetion of National Facome: Use of money has facilitated the distribution of national income among various factors of production. Production ofany commodity results from the cooperation and collective efforts of various ee a... S © scanned with OKEN Scanneroa factors of production. These factors of production are rewarded for their fact, services not in terms of goods and services they produce, but in money term, For instance, labourers are paid for their labour services in terms of mong, wages. 4. Basis of Credit System: Money plays a crucial role in the modern cregi, system. Commercial and business activities are highly dependent upon the credit system of the country. It is money which provides the basis the entire credit system. Without money, credit instruments like cheques, bills of exchange, ete. cannot be used since these credit instruments are clain, over money. For instance, you may not be able to issue a cheque unless yoy have some money deposited in your accounts with the bank. Thus, it is obvious that money performs extremely important functions in modem times. The following flow diagram summarises the functions performed by money. [oEIOEy t vy PRIMARY FUNCTIONS | SECONDARY FUNCTIONS | CONTINGENT FUNCTIONS Nedumat wane or] [5252227] [sorar ] | teanter exchange value ayer value of value Maximisation Employment of Distribution of Basis of sium | [meee | (ememenel) (ey The main functions of money can be summed up in a couplet: “Money is a matter of functions four A medium, a measure, a standard, a store.” 3 Imp. lance of Money _ Money plays an extremely important role in every economy. In the present-day economies, money performs invaluable economic services. Money is the pivot around which all economic activities revolve. In fact, money has acquired such an importanc? in the modern economies that one cannot think of such economies surviving eve? for a few days without the use of money. 254 © scanned with OKEN Scanner| goulowing facts highlight the importance of money: a gportance a to {the Consumers: Money is very important to the i i ‘gsenolds OF ei owner of factor services, households sell their factor cles They use i our, ete. in exchange for money and earn money sco? a tee apaane ra ae income to purchase goods and services. prices of BOCs see es (which are expressed in terms of money) provide Pr rmation on the basis of which consumers decide which commodities they ould buy and in what quantities so as to maximise their total satisfaction. They would also like to save a part of their income for future use. This saving frinitially done in the form of money. significance of Money in Production: Money is equally important to the ’ Soducers in taking decisions regarding ‘what to produce’ and ‘how to produce’. Prices of goods and services, which are expressed in terms of money, provide information to the producers on the basis of which they make production decisions. Generally producers will like to produce those goods the prices of which are relatively higher, given other things. Producers sell goods and services produced in the product market in exchange for money. Similarly, producers purchase various factor services in the factor market with the help ofmoney. Factor prices enable the producers to take decisions about the factor combination with which to produce commodities so as to maximise their profits. 3, Importance of Money in Distribution: Factors of production need to be combined to produce goods and services. This gives rise to the problem of distribution. Money has greatly facilitated the distribution of national product. Factor remunerations such as wages, rent, interest, etc. are made in terms of money. Without money, distribution of national product among factors of production would indeed be very difficult. 4, Significance of Money in Trade: Money has facilitated exchange and trade by overcoming various shortcomings and difficulties of the barter system of exchange. The use of money has simplified the exchange and has thereby promoted trade—both internal and external. 5. Importance of Money in Public Finance: Money is of great help in the field of public finance, i.e., revenue and expenditure of the government. The magnitude of revenue and expenditure of the government in a modern economy isso vast that it cannot be managed without the use of money. Taxes, fees, fines and other forms of revenue of the government are collected in terms of money. hese revenues collected are spent on various developmental and other projects a undertaken by the government which are also expressed in terms of money only. Importance of Money in Capital Formation: Capital formation refers to the process of adding to the stock of capital. This requires investment. ‘aving provides the necessary funds for undertaking investment. Saving is 255 © scanned with OKEN Scannera. | done in terms of money. Savings are mobilised by financial institutions lik, commercial banks from the general public. These funds are lent: to producers for undertaking investment. Money is involved in all these stages—saving borrowing, lending and investment. Thus, money occupies a central place in a modern economy. The old saying that ‘money makes mare go’ holds literally in a modern economy. But money wilj be able to play its role effectively only if it is properly managed. We should not overemphasise the importance of money. It is rightly said that money is a good servant but a bad master. rn Form of Money At present, money consists of paper notes, coins, and deposit money: Paper Notes and Coins: Paper notes and coins together are called currency. Coins refer to the metallic money. Examples of coins are 1, 2,5, 10 and 20-rupee coins. Coins are used for small transactions. Paper money refers to currency notes issued by the central bank of a country. Examples are 5, 10, 20, 50, 100, 200 and 500-rupee notes in India that you carry around to make everyday purchases. In India, virtually all paper money in circulation consists of notes issued by the Reserve Bank of India (RBI), which is the central bank of the country. All paper currency is inconvertible, i.e., it is not convertible into gold or silver. If you assignees look at currency notes, renee say a hundred-rupee — ,.., note, it carries the legend ‘promise to pay the bearer the sum of hundred rupees’ (signed by the Governor of RBI). This legend means that it can be converted into other notes or coins of equal value. Thus, inconvertible paper money is not convertible into anything other than itself. KS zoo & ons 000000 | 256 © scanned with OKEN ScannerIt is important to note three importan 4. Coins and paper not i chara (notes both are token money. Token manzy face value of which in higher than its intrinsic value (meal of the paper). For i ATI, while its intrin: i value is the , 2 100-rupes: note has value of paper used in making it whi ery low. and paper notes are fiat monzy. The: on the er of the government. Th the backing of the government. We consider the value of 2 500-rapee note to be 7500 because the government has declared i 3, Paper notes and coins are legal tender. Being legal tender means that the individual is bound to accept these not d services; they cannot be refused in settlement of paymen' may be limited or unlimited legal tende ited legal tender §: which is acceptable as legal tender only up to a certain maximum amount It cannot be forced upon the people beyond that limi refuse to accept it beyond that limit. Th Unlimited legal tender, on the other hand, has to accept without any maximum limit. In India, currency notes of all denominations are unlimited legal tender. Deposit Money or Bank Money: Deposit money to the deposits held with the bank on the basis of which cheques could be drawn. Cheques are widely accepted these days for making payments because they are easy to use for large transactions and because they are relatively safe mode of payment. It should be noted that cheques themselves are not money. It is the bank deposit, on the basis of which cheques are issued, that is considered to be money. ‘The ‘cheque’ is an instruction to the bank to make payment or to make the transfer of cash to the person to whom. the cheque is issued. It is useful to remember that chequable bank deposits are not legal tender. A person can legally refuse to accept payment through cheques and he © scanned with OKEN Scannercan insist on payment in cash. This is because a cheque will not be honoured by the banks in case of insufficient deposit of the person issuing the cheque with the bank. People may refuse to accept cheques from unknown persons. However, cheques are generally and widely accepted by people for making payments these days. 9.4 INFLATION | Inflation is regarded as a major economic problem everywhere. Inflation has been experienced by all the countries—capitalist or socialist, developed or developing. In fact, inflation has emerged as one of the major contemporary issues all over the world. 9.4.1 Meaning of Inflation Inflation is defined as a process of persistent and appreciable increase in the overall price level. “rE RESIS. Y It is important to note a number of points in this definition of inflation: 1. Inflation is an increase in the overall price level. It refers to increase in prices of many goods and services simultaneously. When the prices of major commodities such as food, shelter, clothes, transportation, medical care, etc., increase simultaneously, the general or overall price level increases. However, this does not mean that all prices rise by the same amount during the period of inflation. 2. Inflation refers to a process of persistent and prolonged rise in prices. A one- time increase in the overall price level is not an inflationary phenomenon. When the overall price level is rising year after year, it is inflationary in nature. Thus, inflation does not refer to a one-time rise in the price level, but rather to a rise in the price level that continues over a long period of time. © scanned with OKEN Scanneryo jnflation refers to a situation of appr i siable or considerable rise in prices. win at yt eo ese Amild or gradual mibe: in the price level, say between 1 to 2 per cont per annum, is essential for toning up and healthy functioning of the economy. Such & mild increase in the price level is not regarded as inflationary rise. It is only when the price rise becomes excessive and unhealthy that it is regarded as jnflationary in character, 4 Inflation is expressed in terms of inflation rate. The inflation rate is the percentage increase in the overall or the average prices of all goods and services from one year to the next. S 942 Types of Inflation Like diseases, inflation shows different levels of severity of rise in prices. On the pasis of rate of inflation, we can distinguish between the following types of inflation: 4, Creeping Inflation: Creeping inflation occurs when the price level increases at a mild rate, say around 2 to 3 per cent per year. It is also known as ‘mild inflation’. This type of inflation is not much of a problem. Walling Inflation: When the rate of increase in the price level is in the range of 3 to 6 per cent per annum, it is called walking inflation. When prices are rising slowly, such a situation is sometimes termed as ‘moderate inflation’. We might classify this as a single-digit annual inflation rate. p Running Inflation: When the price level rises ata faster rate and is generally around 10 per cent to 20 per cent per annum, itis called running inflation. it normally shows two-digit inflation. Running inflation is @ warning signal, indicating the need for controlling it. Galloping Inflation or Hyperinflation: Galloping inflation occurs when prices start rising at double or triple digit rates of 20, 100 or 200 per cent a year. Many Latin American countries such as Argentina and Brazil 50 to 70 per cent per year in 1970s and 1980s. The experienced inflation rates of extreme form of galloping inflation is called hyperinflation. The extraordinary price increases that took place in Germany after World War I represents a situation of hyperinflation. Nothing good can be said about hyperinflation. There is no limit to price rise, and price rise goes out of control during hyperinflation. Money becomes almost worthless, causing severe hardships to people. There is complete collapse of the currency, and economic and political life is disturbed co S © scanned with OKEN Scannerescription of hyperinflation our pockets and come back askets and return with food during hyperinflation. Someone gave the following 4 of Germany, ‘We used to go to stores with money in with food in our baskets. Now we go with money in b in our pockets.” 9.4.3 Demand-Pull Inflation and Cost-Push Inflation Economists have traditionally explained inflation in terms of forces operating from the demand and supply sides. Accordingly, we often talk about demand-pull inflation and cost-push inflation. Inflation originating from the demand forces is called demand-pull inflation. An increase in aggregate demand in the economy leads to demand-pull inflation. Aggregate demand refers to the total demand for goods and services in the economy. Aggregate demand may increase due to increase in consumption expenditure, increase in investment expenditure, increase in government expenditure, increase in population or increase in money supply arising from deficit financing by the government. Whatever the source, if aggregate demand increases rapidly and exceeds the economy’s production, prices will begin to rise. Demand will beat the limited supply of commodities and will bid up prices. Excess demand, i.e., when the demand for goods and services exceeds the supply available at the existing prices, will pull up the price level and will lead to the emergence of inflation. Here, the direction of causation is clear-cut. It proceeds from demand to inflation. The essence of demand-pull inflation is too much spending put against a limited supply of goods. Inflation can be caused by forces operating from the supply side as well. Inflation originating from increase in cost is known as cost-push or supply-side inflation. Cost-push inflation may be caused by increase in wage cost, increase in profit margin or increase in input. prices like oil prices. If money wages increase, cost per unit will increase. As a consequence, producers raise their prices to cover the higher cost. A series of increase in wage rates leads to a persistent price rise. Usually, trade unions are regarded as the culprit of cost-push inflation since they are able to press the employers to grant increase in wage rates. However, recent experience has shown that oligopolist and monopolist firms may raise the prices of their product so as to earn higher profits. Since 1970s, another set of players has entered the cost-push fray: oil. Inflation has resulted in response to a sharp jump in oil prices. This phenomenon of sharp rise in oil prices is sometimes known a8 supply shock. 260©. A A ——— © scanned with OKEN Scannergon Friedman (1912-2006) C0 Friedman, an American economist and yilligian, Was a Professor at the University of sti for more than three decades, He was awarded eine in Beonomics in 1976 fr his contribution to, ang other things, monetary economies. He is bi ered as the most influential economist of the cone half of 20th century. He was the main proponent sepanetarist school of economies. He maintained that | ie is a close relation between money supply and fatation. He emphasised that “inflation is always and serywhere 2 monetary phenomenon.” He advocated that inflation should be regulated with contractionary monetary policy. He rejected the use of fiscal policy fsa tool of demand management, unlike the Keynesian school of economics. 44 Effects of Inflation While discussing the effects of inflation, it is important to note that a mild degree ofinflation has a positive effect on the functioning of an economy. Increase in prices afgoods and services generally leads to increase in the profit margin. This provides stimulus to the producers to undertake more investment. As a result, production and employment increases. That is why it is believed that a mild degree of inflation isnot only desirable, but is necessary for the healthy functioning of an economy and for economic growth. A mild inflation lubricates the wheels of trade and industry. However, economists generally believe that galloping or hyperinflation has quite afew serious and harmful consequences for the economy. These harmful effects of inflation are discussed below: 1. Effect on Production: While a mild degree of inflation activates the economy by increasing investment, production and employment, hyperinflation has various adverse effects on production. These harmful effects of inflation on Production are as follows: ® A sharp rise in prices, particularly when it is not anticipated, creates a situation of uncertainty in the economy. The conditions of uncertainty in the economy have adverse and dampening effect on investment and Production activities. (i) Inflation causes misallocation of resources by encouraging investment in speculative activities such as purchasing of shares, land, etc., and in oarding of goods so as to make quick and easy profits. These types of 261 © scanned with OKEN Scannerinvestments do not help in creating productive capacity in the economy, As a result, productive activities in the economy suffer. (iii) Inflation reduces degree of competition in the economy. It creates a situation of sellers market in the sense that producers are able to sell whatever they produce. Inefficient producers are protected thereby. 2. Effect on Distribution of Income: During the periods of inflation, all prices and incomes do not increase at the same rate. This leads to change in relative prices and incomes. As a result, inflation leads to | inequitable and arbitrary redistribution of income and wealth among different sections _.W, in the economy. During inflation, a section of the society may gain, while another section may lose. An advantage to one group of people may be at the cost of the other groups. It is like robbing Peter to pay Paul. Effects of inflation on different sections of society are discussed below: (i) Debtors and Creditors: It is commonly believed that debtors tend to benefit at the cost of creditors during inflation. Debtors benefit during inflation because they had borrowed money when the purchasing power of money was high and they return it when its purchasing power has fallen due to price rise. Though they pay the fixed rate of interest and pay back the same principal amount in nominal terms when they return the loan, but in real terms they pay less. Certainly, if loan %5000 to some person to be paid back in a year and prices increase by 10 per cent in the meantime, I will get back 10 per cent less in real terms than when I loaned this amount to that person. Inflation would have opposite effect on creditors. They tend to lose during inflation since the loan repaid and interest received would have less real value as a result of rise in prices. They receive the same amount in money terms but less amount in real terms. (ii) Wage Earners and Salaried Class: Wage earners and salaried class tend to lose during inflation. Though in the modern economies, wages and salaries are linked with cost of living, even then the labourers and salaried class are likely to lose during inflation mainly for two reasons: First, in most cases increase in wages and salaries generally fails to keep pace with the rising prices. Second, even though wages and salaries may eventually rise during inflation, there is a time lag between the price rise and increase in wages and salaries. As a result, wage earners and salaried class lose during the intervening period. idleincome © scanned with OKEN Scanner4p Fised-income Earners: Pens rile ioner: imi is w ups suffer during inflati ners and similarly placed fixed-income ation, Reti ‘tired people who survive on pensions verre inflation. Even when yee nceme of the pensioners remains same Pensions are revised periodically, increase in nsion does not keey i is ve P pace with the rising prices. Second, pensioners keep ir savings in th inet Sots in the fore bank and postal deposits which give them @ Jose purchasing power of their rer Consequently, fixed-income earners Ey profit Barners: Entrepreneurs vd income during periods of inflation. are derived from profits, tend ; traders, merchants, ete., whose incomes » tend to benefit during inflation. It has been generally observed that when prices are risii ally high¢ wean anticipated. Entrepreneurs tond teens edt pret beca igher ices leads to i © nd to earn windfall profits because rise in price’ increase in factor prices and cost of production only after some time gap. Moreover, entrepreneurs earn profits due to increase in the value of stock of goods they possess. (v) Investors: Inflation has a mixed effect on investors. Some investors tend to gain while others are likely to lose during inflation. It is possible to distinguish between two types of investors, namely investors in equities and investors in fixed-interest earning assets. Investors in equities of the companies or unit trusts gain during inflation since dividends increase as a result of increase in corporate profits during the period of inflation. On the other hand, small investors who invest their money in the form of bonds, debentures and deposits with the commercial banks, post offices, etc., tend to lose because they receive a fixed interest income from such investment. 3. Effect on Savings: Inflation is likely to have adverse effect on savings. Inflation wipes out savings. The real value of accumulated cash evaporates. Small savers, who put their savings in the form of bank deposits, National Saving Certificates and other government securities, find the real value of their savings falling during the period of inflation. This reduces motivation for saving. At the same time, ability of people to save will decrease because with their given money income, they have to spend more for purchasing the same quantity of goods and services they require. 4. Effect on Balance of Payments: Inflation generally has an adverse effect on balance of payments. If the rate of inflation in a country is higher than inother countries, the relative competitiveness Of this country’s products in the world market would decrease. Its exportables would become relatively Richer lacls ‘ding toa fallin exports. On the other hand, €xpensive in the world markets, leading 4 te of increase in pri its importables would become relatively cheaper since ra eof increase in prices — © scanned with OKEN Scanneras of imported goods is lower. This would increase its imports. Thus, demang s this country’s exports would decrease while that of imports would increase This would have adverse effect on the balance of payments. 5. Confidence in the Currency: A high rate of inflation can underming the confidence of people in currency. When people lose confidence in curren, money cannot function as money. People will not like to hold curren’ This will lead to flight from money. This is what happened in Germany, during the hyperinflation of 1923. There was such a breakdown of pyjj, confidence in money that people refused to accept ‘Mark’ (German curreney) Money gave place to barter system of exchange because people Starteg preferring commodities over money as a medium of exchange. 6. Social and Moral Degradation: Periods of hyperinflation are often associate with social and moral degradation. Inflation has led to thefts and robberies because some people would like to get income in illegal and undesirable ways so as to survive. Inflation is the period during which small-time crimes thrive, Corruption breeds during inflation, 7. Political Instability: Continued inflation in many cases has shaken the foundations of the political system. Inflation has become a major political issue during many elections. History is full of instances when many a government lost power because of persistent rise in prices. To conclude, inflation has serious economic, social and political consequences, Effects of Inflation at a Glance . Effect on Production. . Effect on Distribution of Income. . Effect on Savings. . Effect on Balance of Payments. . Confidence in the Currency. . Social and Moral Degradation. . Political Instability. NOORONG 9.4.5 Control of Inflation* In view of the serious consequences of inflation, it is essential that inflation must effectively controlled before it assumes a serious proportion and thereby threale™ the very existence of the economic and Political system of the country. * Optional study, 3 264 © scanned with OKEN Scannerei measures to control inflation are discussed bel tary Measures: Mon 7 ed below: & fe by influencing the ae fe at controlling the supply of a ae 'Y and cost of b: A counti ; of bank credit. The central panko oo te ae ta pees with the task cfcincin Muletaey policy. i oe eae aa rictive or tight monetary policy to control inflation. ese pasing the cost of ee a reducing the availability of bank credit fe ta tneacure: toi credit. The central bank may adopt quantitative and qualitative mens implement its anti-inflationary restrictive monetary icy. Qu: e measures such as open market operations, cash reserve poli ratio and oe rate, would influence the availability of bank credit and its cost, i-e., interest rate. Selective credit control measures aim at influencing the purpose for which bank credit is made available and thereby affect the direction of bank credit. These methods are discussed in detail in the next chapter. 3. Fiscal Measures: Fiscal policy can also be used to control i policy is the policy of the government revenue and expenditure. Contractionary d to control demand-pull inflation. Contractionary of reducing government expenditure and increasing ontractionary fiscal policy can public expenditure and public inflation. Fiscal fiseal policy can be use fiscal policy is the policy government revenue. The anti-inflationary o be implemented through the tools of taxation, borrowing in the following ways: 1k of anti-inflationary fiscal policy is to increase g the tax rate and by imposing new taxes etc. fthe taxpayers and thereby reduce () Taxation: The major plan the tax burden by increasin| This will reduce the disposable income 0 their consumption expenditure. (ii) Public Expenditure: Public expenditure, expenditure, must be reduced. For ‘example, be reduced. This will lead toa direct decrease public expenditure is an important component of ii) Public Borrowing: Public borrowing, i.e. borrowing by the government from the public, can also be used to control inflation. Public borrowing enables the government to meet its excess expenditure and thereby reduces ee ne ao ereit financing. Moreovety PAY ee reducing the amount of purchasing power with the public, and thereby in reducing their expenditure. 265 particularly unproductive public expenditure on defence should in aggregate demand because f aggregate demand. © scanned with OKEN Scanneray 3. Income Policy: In order to curb cost-push inflation, there is the need fo, adopting appropriate income policy. The primary objective of income poliey is to ensure that wages, salaries and other incomes do not increase much, This means that cost per unit does not increase much. However, it is difficul, to implement such a policy, particularly with regard to wage income in view of pressure of the trade unions. 4. Price Control and Rationing: A direct measure to control inflation ig to introduce price controls and rationing of essential goods. Under price control policy, the government fixes the maximum price at which certain commodities can be sold. Since the maximum price is set below the free market equilibrium price, price ceiling is likely to create scarcity of goods. Therefore, price control policy is often accomplished by rationing. Under rationing, a specified quantity of goods is given to the consumers at the controlled price. Price controls and rationing may be effective policies of controlling inflation. However there are various practical difficulties in the implementation of this policy. For example, this policy may give rise to black market. Black market is the market where goods are sold unlawfully at higher price than at the controlled price. 5. Increasing the Availability of Goods: The basic solution to the problem of inflation is to increase the availability of goods in the economy. The following measures need to be taken to increase the availability of goods. G@) Production should be increased by providing subsidies to the producers and by removing bottlenecks impeding production. Gi) Domestic production of essential goods may be supplemented by imports of these goods so as to reduce the shortages and thereby reduce inflationary pressure. To sum up, inflation can be controlled by operating from both the demand side and the supply side. Demand can be reduced through monetary and fiscal policies. Both monetary and fiscal polices are tools of demand management, However, it is essential to control inflation by operating from the supply side as well. It is necessary to increase production so as to increase the general availability of goods. At the same time, price control and rationing policy should be introduced so a8 to make the essential goods of mass consumption available at controlled prices. However, we should accept the fact that the rate of inflation may be brought down by pursuing various measures, but inflation cannot be controlled altogether. Most macroeconomists believe that a moderate rate of inflation, generally up to 3 per cent or 50, is good for the efficient working of the economy and for promoting economit growth. 266 eee © scanned with OKEN Scanner