Money Supply and Interest Rate: Central banks regulate the money supply in a country’s economy. When there is a threat of inflation, the central bank intervenes to control the money supply and keep inflation under control.
The interest rate determines the mechanism by which central banks control inflation. The money supply and the interest rate move in opposite directions. Interest rates tend to fall as the money supply grows, and vice versa.
Assume that the economy is experiencing slow growth at any given time. The central bank uses its monetary policy tools to intervene (Bank Rate, Repo Rate, and Statutory Liquidity Rate). The result of such loose monetary policy is an increase in the economy’s money supply.
The increased money supply means that there will be more money in the economy than people are willing to hold at any given time. What will happen to the money that is left over? People will not want their extra cash sitting in their wallets. As a result, they will attempt to invest it in alternative financial instruments such as bonds.
As a result, demand for financial assets (bonds) will increase, causing bond prices to rise. Interest will fall as bond prices rise, according to a well-established financial economics relationship.
A fall in interest rate>>> Increase in Investment>>> Increase in output/production>>> increase in employment and national income. Hence end of slowdown.
Government Spending and Interest Rate.
The interest rate and equilibrium income are both affected by fiscal policy. A rise in interest rates will result from an increase in government spending (expansionary fiscal policy) to boost economic activity. This occurs because the economy has a finite amount of saving capacity at any given time. When the government spends more, it competes with the private sector for the few savings available. The interest rate is likely to rise as a result of this process.
The Cost of Inflation
Inflation is regarded as detrimental to an economy because it reduces the purchasing power of money. When prices rise, each rupee you own buys a smaller amount of goods and services. As a result, inflation reduces people’s real income and makes them poorer. This is especially true in a country like India, where the informal sector and agriculture sectors are both large.
Because the majority of the population works in the informal and agricultural sectors, where minimum wage laws and social security benefits do not apply, people in these sectors bear the brunt of inflation. Wages in these industries are not inflation-indexed. As a result, when prices rise, their wage does not, and they lose as a result of a decrease in real income on one hand and no increase in wages on the other. There are also two associated social costs of inflation:
The Shoe Leather Cost
Assume that inflation in an economy has been increasing at a rate of 5% over the last few years. In this case, everyone will expect inflation to remain at 5% in the future. In this case, all economic transactions will be adjusted for a 5% inflation rate. In such an inflationary scenario, the only cost of inflation will be the cost of shoe leather.
The cost of shoe leather arises as a result of the cost of holding money during inflation. People will start depositing their money in banks to earn interest rates because inflation destroys the real value of money and cash holds no interest.
The less cash they have, the more they have to withdraw money from banks or ATMs. Going to the bank is not free, both in terms of time and the transaction fees imposed by banks on ATM and counter withdrawals, as well as the cost of travel to banks, will all add to the cost of Shoe Leather.
Menu Cost
Another social cost linked to expected inflation is menu cost. The term “menu cost” comes from the restaurant industry. Menu costs arise as a result of the business’s frequent price changes due to inflation. The change necessitates the firm to bear costs associated with the printing of new catalogs, price lists, and other materials. They must also spend money on advertising to inform customers of their new prices.
Practice Questions for UPSC Prelims
Ques 1: Consider the following statements regarding the concept of inflation:
I. A rise in the general level of prices; a sustained rise in the general level of prices; persistent increases in the general level of prices ; an increase in the general level of prices in an economy that is sustained over time; rising prices across the board —is inflation.
II. If the price of one good has gone up, it is not inflation; it is inflation only if the prices of most goods have gone up.
Which of the following statement(s) is/are correct?
a. Only I
b. Only II
c. Both I and II
d. Neither I nor II
Answer: Option C
Explanation: A rise in the general level of prices; a sustained rise in the general level of prices; persistent increases in the general level of prices; an increase in the general level of prices in an economy that is sustained over time; rising prices across the board —is inflation.
These are some of the most common academic definitions of inflation. If the price of one good has gone up, it is not inflation; it is inflation only if the prices of most goods have gone up.
Ques 2: Consider the following statements regarding the monetarist view of Cost-Push inflation:
I. For monetarists, ‘cost-push’ is not a truly independent theory of inflation—it has to be financed by some extra money.
II. The extra money is created by the government via wage revision, public borrowing, the printing of currency, etc.
III. A price rise does not get automatically reciprocated by consumers’ purchasing.
Which of the following statement(s) is/are correct?
a. Only I
b. Only II
c. Both I and II
d. Neither I nor II
Answer: Option C
Explanation: For monetarists, ‘cost-push’ is not a truly independent theory of inflation—it has to be financed by some extra money (which is created by the government via wage revision, public borrowing, the printing of currency, etc.). A price rise does not get automatically reciprocated by consumers’ purchasing.
Basically, people must have got some extra purchasing power created that’s why they start purchasing at higher prices also. If this has not been the reason, people would have cut down their consumption (i.e. overall demand) to the level of their purchasing capacity and the aggregate demand for goods would have gone down. But this does not happen. It means that every cost-push inflation is a result of excessive creation of money—increasing money flow or money supply.
Ques 3: Which of the following measures could be taken to check existing inflation in an economy:
a. The government may go for the import of goods which are in shortsupply— as a short-term measure.
b. As a long-term measure, governments go on to increase production to match the level of demand.
c. The governments may try to cool down the price by cutting down the production cost of the goods showing price rise with the help of tax breaks—cuts in the excise and customs duties.
d. All of the above
Answer: Option D
Explanation: Governments around the world distanced themselves from this debate and have been taking recourse to all possible options while controlling inflation. The governments resort to the following options to check rising inflation:
As a supply-side measure, the government may go for the import of goods that are in short supply— as a short-term measure (as happened in India in the case of ‘onion’7 and meeting the buffer stock norm of wheat). As a long-term measure, governments go on to increase production to match the level of demand. Storage, transportation, distribution, hoarding are the other aspects of price management in this category.
As a cost side measure, governments may try to cool down the price by cutting down the production cost of the goods showing price rise with the help of tax breaks—cuts in the excise and custom duties (as happened in June 2003 in India in the case of crude oil and steel). This helps as a short-term measure. In the long-term, a better production process, technological innovations, etc. are helpful. Increasing the income of the people is the monetary measure to avoid the heat of such inflation.
Quick Questions on Inflation for UPSC Preparation
What causes Inflation?
There are numerous factors that drives the inflation in the country. However there are some major factors that causes inflation. These are rising prices of fossil fuels, increase in money supply, rises in wages, disruption in supply chain, and rise in food prices.
What are the solutions to inflation?
The Reserve Bank of India used to control the inflation. RBI used to sell the securities in the market to lower the liquidity from the market.
What are the effects of inflation?
Inflation may causes losses to some group and may causes gains to other group. It can have both negative and positive effects. However, sudden rise in inflation is negative for overall inflation.