Inflation

Inflation is an increase in the overall level of prices.

According to Milton Friedman- inflation is a
sustained increase in price.
Defined as:
A SUSTAINED RISE IN THE AVERAGE LEVEL OF
PRICES
It implies a continuously rising trend in general
prices.

Deflation, is an continuously decreasing in the

overall level of prices.

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 Inflation
Causes of Inflation

Demand Pull Factors

Defined as:
- Excess demand condition pulls up prices of
goods and services and lead to price rise.

Cost pull factors.

Some factors of production are responsible for
rising the cost of production it leads to price
rise.
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 Inflation
Demand pull factors are as follows.

Population pressure.
Mounting govt. expenditure
Growing supply of money
Growing deficit financing
Growing black money.

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 Inflation
Cost Push factors are as follows.

Oil price hike.

Slow growth rate of agriculture production.
Increase in wages and bonus.
Rise in administered prices.
Increase in tax rate.

4
 Inflation
Other factors.

Increase in procurement prices.

Creation of artificial crisis.
Devaluation of domestic currency.

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 Costs and Consequences of Inflation

Title: Overflowing Riches. Date: 1922. 
Description: A shopkeeper using a tea chest to store money which 
won't fit in the cash register during Germany's high inflation. 
 

Description: Children using 
notes of money as building 
blocks during the 1923 German 
inflation crisis. 
 Costs and Consequences of Inflation
 Money loses its value and people lose confidence in
money as the value of savings is reduced
 Inflation can get out of control - price increases
lead to higher wage demands as people try to
maintain their living standards.
 Consumers and businesses on fixed incomes lose
out because the their real incomes falls
 Employees in poor bargaining positions lose out
 Inflation can favor borrowers at the expense of
savers – because inflation erodes the real value of
existing debts
 Inflation can disrupt business planning and lead to
lower investment
 Inflation is a possible cause of higher
unemployment
 Rising inflation is associated with higher interest
rates - this reduces economic growth and can lead
to a recession
 Types of inflation
 Creeping inflation
 It is a situation in which the rise in general
price level is at a very slow rate over a period
of time. Under creeping inflation, the price
level raises upto a rate of 2% per annum. A
mild inflation is generally considered a
necessary condition of economic growth.

 Walking inflation
 Walking inflation is a marked increase in the
rate of inflation as compared to creeping
inflation. The price rise is around 5% annually.
 Types of inflation
 Running inflation
 Under running inflation, the price
increases is about 8% to 10% per annum.

 Hyper inflation
 Galloping inflation is a full inflation. Keynes
calls it as the final stage of inflation. It is a
stage of inflation which starts after the
level of full employment is reached. Here
price level rise
 Inflation
Way to control inflation.
 (1)Monetary Policy
Monetary policy is a policy that influences the
economy through changes in the money
supply and available credit.
(a) Quantitative controls
(b) Qualitative controls .

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 Inflation
Way to control inflation.
Fiscal Policy
 It is the budgetary policy of the government
relating to taxes, public expenditure, public
borrowing and deficit financing.
Changes in taxation
Changes in Govt. Expenditure
Public borrowing
Control of deficit financing
 

12
 Inflation
Way to control inflation.
Others Measures:
Price support programme.
Provision subsidies.
Imposing direct control on prices of essential
items.
Rationing of essential consumer goods in case
of acute emergency.

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 Business Cycle
Gross Domestic Product is a measure of the value of all
outputs in an economy in a single year - the value of all
goods and services produced

Gross domestic Product does not increase at a constant

rate over time – there are variations in growth rate.

There can be times of negative growth or positive growth

i.e. GDP decreases & GDP increase.

 These periodic movements in output, prices, and

employment are known as the Economic or Business Cycle
 Various phases of business
Cycle
Expansion of business activities.

Peak of boom or prosperity.

Recession

Trough the bottom of depression

Recovery & expansion.

16
 Expansion Recession Expansion

Peak
Do n
ur
Total Output

wn t
tu Up
rn Secular
growth
trend
Trough

0
Time
 Various phases of business
Cycle
Expansion of business activities.

Peak of boom or prosperity.

Recession

Trough the bottom of depression

Recovery & expansion.

 Parts of Economic Cycle -
 Low levels of
Boom
unemployment – shortages of labour occur pushing
up wage rates

High levels of consumer borrowing and spending

Firms working at full capacity

Profit levels high

Inflation Increasing

Interest rates increasing

Boom in housing market

 Parts of Economic Cycle –
Recession
Growth rate of GDP is falling or negative

Firms decrease production and reduce stocks

Unemployment rises

Inflation falls

Investment falls

Firms suffer from falling profits, falling returns

of investment, redundancy costs.

 Parts of Economic Cycle –
Recovery

Consumer confidence grows – leading to increased

borrowing and spending

Firms increase output – build up stock levels

Spare capacity used, then

Investment occurs

Unemployment falls – it make take more than a year of

recovery for large changes in unemployment levels
 Government and Economic
Cycle

The government will attempt to control

fluctuations in economic growth

Aims to achieve growth at around trend level

Use Fiscal and Monetary policy to achieve

this objective.
 Profit
P
rofit means different thing to different people.
B
usinessman, Accountant, and Economist used the term
profit with different meaning.
F
or Layman profit means all income flow to the investor.
F
or Accountant profit means excess of revenue over all the
paid-out cost.
F
or economist concept of profit is of pure profit called as
“economic profit”. Pure profit is return above the
opportunity cost.
 Profit
A
ccounting Profit Vs Economical profit.
A
ccounting Profit -
A
ccounting profit is surplus of revenue over and above paid
cost. Including manufacturing and administration cost.
A
ccounting profit can be calculate as follows

= TR- (W+R+I+M)
Wh
ere W = wages, R= Rent,

I = Interest, M = Material.
 Profit

ccounting Profit Vs Economical profit.

conomical Profit -

t takes into account the implicit and explicit

costs. Implicit cost is opportunity cost.

conomical Profit=

TR- (Explicit Costs +Implicit costs)

 Theories of profit
Wh
at are the source of profit?
Eco
nomist have given various opinion on this question which has
created controversy and led to emergence of various theories
of profit.
Prof
it as Rent of ability -
This
theory is given by F.A. Walker.
Acc
ording to him profit is the rent of “exceptional abilities that
entrepreneurs may posses”.
As
like land profit is the difference between the earning of least
and most efficient entrepreneur.
 Dynamic Theory.
This theory is given by J. B.Clark’s F.A.
Walker.
According to him profit arise in only a
dynamic economy not in a static one.
Static economy is one in which
absolute freedom of competition, population capital are stationary, product are homogeneous
(perfect competition).
Dynamic economy is one which
1) Increase in population.
2)Increase in capital formation.
3)Improvement in production technique
4) Multiplication of consumer wants.
Entrepreneur how take advantage of
changing condition make profit.
In dynamic economy dis appearance
and re emergence of profit is continuous process.
 Hawleys Risk
Theory of profit. -
This theory is
given by F.B. Hawley in 1893.
According to
him profit is simply the price paid by society for assuming business risk.
In business risk
arise for such reason as obsolescence of product, fall in price, non
availability of certain raw material etc.
According to
him profit consist of two part- 1) Risk which is all ready suffered or
assumed by entrepreneur.
2)Inducement to
suffer the consequences of being exposed to risk in their entrepreneur
adventure.
The reason why
he mentioned profit above actuarial is because risk taking is annoying,
trouble some, disturbance anxiety of various kind.
 Knights
theory of profit--
 Accordin
g to him profit is residual return for bearing uncertainty not risk.
 He
divided risk into two part. Calculable & non calculable risk.
Calculable risk is those whose probability of occurrence can be
estimated with available data. (Fire, theft, accident etc). Next is
the risk of which occurrence can not be estimated such as change
in test of consumer, change in government policy etc. that is
uncertainty faced by entrepreneur.
 Entrepre
neurs are making decisions under uncertain condition. In this
condition if their decision proved right they would earn profit.
 Theories of profit
Schumpeter’s innovation theory of profit--

This theory was developed by Joseph Schumpeter.

His theory of profit is embedded in his theory of

Economic development.
His theory start with the stationary of static economic

equilibrium. In such profit can be made only by introducing innovations in business, it may includes-
1.Introducing of new product.
2.New method of production.
3.Opening of new market
4.New sources of raw material
5.Organising the industry in new innovative manner.

According to him profit is residual return for bearing


uncertainty not risk.
He divided risk into two part. Calculable & non

calculable risk. Calculable risk is those whose probability of occurrence can be estimated with available data.
(Fire, theft, accident etc). Next is the risk of which occurrence can not be estimated such as change in test of
consumer, change in government policy etc. that is uncertainty faced by entrepreneur.
Entrepreneurs are making decisions under uncertain

condition. In this condition if their decision proved right they would earn profit.
MONETARY POLICY
 MONETARY POLICY

INTRODUCTION

Monetary Policy is essentially a programme of

action undertaken by the Monetary
Authorities, generally the Central Bank, to
control and regulate the supply of money with
the public and the flow of credit with a view to
achieving pre-determined macro-economics
goals.

At the time of inflation monetary policy seeks

to contract aggregate spending by tightening
the money supply or raising the rate of
 MONETARY POLICY

OBJECTIVES

 To achieve price stability by controlling inflation

and deflation.

 To promote and encourage economic growth in

the economy.

 To ensure the economic stability at full

employment or potential level of output.
 SCOPE OF MONETARY POLICY
The scope of Monetary policy depends on two factors

1.Level of Monetization of the Economy –

In this all economic transactions are
carried out with money as a medium of exchange .
This is done by changing the supply of and demand
for money and the general price level. It is capable of
affecting all economics activities such as Production,
Consumption, Savings, Investment etc.

2. Level of Development of the Capital Market

Some instrument of Monetary Policy are
work through capital market such as Cash Reserve
Ratio (CRR) etc. When capital market is fairly
developed then the Monetary Policy effects the level
of economic activities by the change in capital
 OPEN MARKET OPERATIONS

• The open market operations is sale and purchase of

government securities and Treasury Bills by the
central bank of the country.

• When the central bank decides to pump money into

circulation, it buys back the government securities,
bills and bonds.

• When it decides to reduce money in circulation it

sells the government bonds and securities.

• The central bank carries out its open market

operations through the commercial banks.
 Discount Rate or Bank Rate policy

 Discount rate or bank rate is the rate at which

central bank rediscounts the bills of exchange
presented by the commercial bank.

 The central bank can change this rate

increase or decrease depending on whether it
wants to expand or reduce the flow of credit
from the commercial bank.
 Working of the discount rate policy

• A rise in the discount rate reduces the net

worth of the government bonds against which
commercial banks borrow funds from the
central bank. This reduces commercial banks
capacity to borrow from the central bank.

• When the central bank raises its discount rate,

commercial banks raise their discount rate too.
Rise in the discount rate raises the cost of bank
credit which discourages business firms to get
their bill of exchange discounted.
 Cash Reserve ratio
• The cash reserve ratio is the percentage of total deposits
which commercial banks are required to maintain in the form
of cash reserve with the central bank.

• The objective of cash reserve is to prevent shortage of cash for

meeting the cash demand by the depositors.

• By changing the CRR, the central bank can change the money.

• When economic conditions demand a contractionary monetary

policy, the central bank raises the CRR. And when economic
conditions demand monetary expansion ,the central bank cuts
down the CRR.
 Statutory Liquidity Requirement

• In India ,the RBI has imposed another reserve

requirement in addition to CRR. It is called
statutory liquidity requirement.

• The SLR is the proportion of the total deposits

which commercial banks are statutorily
required to maintain in the form of liquid
assets in addition to cash reserve ratio.
 Credit Rationing
 When there is a shortage of institutional credit available
for the business sector, the large and financially strong
sectors or industries tend to capture the lion’s share in
the total institutional credit.

 As a result the priority sectors and essential industries

are of necessary funds.
 Below two measures are generally adopted:
 Imposition of upper limits on the credit available to large
industries and firms
 Charging a higher or progressive interest rate on the
bank loans beyond a certain limit.
 Change in Lending Margins

• The banks provide loans only up to a certain

percentage of the value of the mortgaged
property.

• The gap between the value of the mortgaged

property and amount advanced is called Lending
Margin.

• The central bank is empowered to increase the

lending margin with a view to decrease the bank
credit.
 Moral Suasion

 The moral suasion is a method of persuading

and convincing the commercial banks to
advance credit in accordance with the
directives of the central bank in overall
economic interest of the country.

 Under this method the central bank writes

letter to hold meetings with the banks on
money and credit matters.
Expansionary Policy / Contractionary Policy

An Expansionary Policy increases the total supply of

money in the economy while a Contractionary Policy
decreases the total money Supply into the market.

Expansionary policy is traditionally used to combat a

recession by lowering interests rates.

Lowered interest rates means lower cost of credit which

induces people to borrow and spend thereby providing
steam to various industries and kick start a slowing
economy.
 Expansionary Policy /
Contractionary Policy
A Contractionary Policy results in increasing interest
rates to combat inflation.
An Economy growing in an unconstrained manner leads
to inflation
Hence increasing interest rates increase the cost of
credit thereby making people borrow less.
Due to lesser borrowing the amount of money in the
system reduces which in turn brings down inflation.
A Contractionary Policy is also known as TIGHT POLICY
as it tightens the flow of money in order to contain
Inflationary forces.