Monetary Policy -- The behavior of the Central Bank of the country concerning the nation’s money supply. Instruments of Monetary Policy --
1. Open Market Operations (OMO) – In this, the central bank purchases or buys govt. securities in the open market. This is used to expand or contract the amount of reserves in the system and thus the money supply. It buys bonds in exchange of money thus increasing the stock of money, or it sells the bonds in exchange for money this reducing the stock of money.
2. Cash Reserve Ratio (CRR) - Banks are required to keep a fraction of their deposit liabilities with the RBI, which ensures safety and liquidity of these deposits. When the RBI has to control inflation, it raises the CRR, so that banks will have less money to give out as loans, and hence less money supply in the economy.
3. Statutory Liquidity Ratio (SLR) - It is the amt of assets (cash, gold, etc.) which the banks have to maintain as reserves with the RBI. It is used in the same way as the CRR. The diff between the both is that in SLR, it is cash, gold or any other securities, in CRR it is only cash.
4. Repo rate - Repo rate is the interest rate at which the RBI lends to the commercial banks. Currently it is 8.5%. Bank rate and Repo rate are the same. The only difference being that the former is for longer period of time and the latter for shorter period of time. When the repo rate is increased, borrowing from RBI becomes more expensive. Now, for a bank to make profit, it'll have to keep its base rate higher than this, and thus with increasing repo rate, the loans in the market also gets expensive, thus controlling the money supply.
Reverse repo is the rate at which RBI borrows money from banks. Banks are always happy to lend money to RBI since their money are in safe hands with a good interest. An increase in reverse repo can cause the banks to transfer more funds to RBI which causes the money to be drawn out of the banking system, hence leaving the banks with less cash to loan out to the people. Hence, there is less money supply in the economy.
--- > A Tight Monetary Policy is to constrict spending in an economy that is seen to be growing too quickly, or to curb inflation when it is rising too fast.
Fiscal Policy – These are the policy decisions taken by Govt. that affects the Govt. spending and the tax rates. Any alteration in either of them affects the Aggregate demand in the economy and the distribution of income, thus controlling the flow of money in the economy.
INFLATION Inflation is the increase in the overall price level. A sustained inflation occurs when the over all price level continues to rise over some fairly long period of time. Inflation is different from a price rise of an individual commodity which is due to the micro demand-supply factors.
Demand-pull inflation – When the price levels increase due to the increase in Aggregate Demand in the economy. It’s a result of “too much money chasing too many goods” – meaning, less supply and more demand of the goods. When this happens across the entire economy for all goods, it is known as demand-pull inflation.
Factors that increase the Aggregate Demand - The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, an increase in government purchases can increase aggregate demand, thus pulling up prices. Another factor can be the depreciation of local exchange rates, which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases, thereby raising the overall level of aggregate demand (we are assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy). Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners. Finally, if government reduces taxes, households are left with more disposable income in their pockets. This in turn leads to increased consumer spending, thus increasing aggregate demand and eventually causing demand-pull inflation. The results of reduced taxes can lead also to growing consumer confidence in the local economy, which further increases aggregate demand.
Cost-push inflation - Inflation can also be caused by an increase in costs, referred to as Cost-push inflation or supply side inflation. Several times the oil prices on world markets are increased sharply, and since oil is used as an input in virtually every line of business, costs increase. An increase in the costs of production results in fall in Aggregate Supply. Cost-push inflation basically means that prices have been “pushed up” by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing inflation.
Stagflation – It occurs when output is falling at the same time that prices are rising. A possible cause of stagflation is the increase in costs.
---> The govt. could counteract the increase in costs by engaging in an expansionary monetary policy (increase in Govt. spending or money supply or decrease in taxes). But this results in price level being at a even higher level now.
Hyperinflation – A period of very rapid increase in the price level.
When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value.
When associated with wars, hyperinflation often occurs when there is a loss of confidence in a currency's ability to maintain its value in the aftermath. Because of this, sellers demand a risk premium to accept the currency, and they do this by raising their prices.
One of the most famous examples of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion, doubling every 28 hours.
Deflation and Disinflation - A slowing in the rate of price inflation. Disinflation is used to describe instances when the inflation rate has reduced marginally over the short term. Although it is used to describe periods of slowing inflation, disinflation should not be confused with deflation.
Deflation is a general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the excessive drop in prices to a minimum.
-Abhishek Anand
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