BUSINESS ENVIRONMENT

For: Mr. Kaushal Kishore

Assignment No.-1
Submitted by: Deepak Kumar
PGDPMX-10, PDPU, Gandhinagar
Question: What is inflation? Discuss role of Monetary Policy to control
inflation.

1. INFLATION
“Inflation” is commonly understood as a situation and rapid general increase in the level of
prices and consequent deterioration in the value of money over a period of time. When the
general price level rises, each unit of currency buys fewer goods and services. It also reflects
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.

The term "inflation" originally referred to increases in the amount of money in circulation,
economists use the term "inflation" to refer to a rise in the price level. An increase in the money
supply may be called monetary inflation, to distinguish it from rising prices, which may also for
clarity be called 'price inflation'. Economists generally agree that in the long run, inflation is
caused by increases in the money supply. However, in the short and medium term, inflation is
largely dependent on supply and demand pressures in the economy.
Thus, inflation is statistically measured in terms of percentage increase in the price index, as a
rate percent per unit of time. Wholesale Price Index (WPI) is used to measure inflation in India.
Alternatively Consumer Price Index (CPI) or Cost of Living Index number can also be adopted
in measuring the rate of inflation. WPI covers 435 commodities. Weights of the commodities
are derived based on the value of quantities traded in the domestic market. There are 3 major
components of the WPI. They are

a) Primary Articles
b) Fuel, Power, Light and Lubricants
c) Manufactured Products

Primary Articles are further sub-grouped as food articles, non-food articles and minerals. The
index of Petrol, Diesel, Kerosene and Liquefied Petroleum Gas (LPG) constitute the major group
of ‘Fuel and power’.

Other economic concepts related to inflation include:

Deflation – a fall in the general price level.

Disinflation – a decrease in the rate of inflation.

Hyperinflation – an out-of-control inflationary spiral.

Stagflation – a combination of inflation, slow economic growth and high unemployment 

Reflation – an attempt to raise the general level of prices to counteract deflationary pressures.

2. CAUSES OF INFLATION
 Over-expansion of Money Supply: Increase in the supply of the money in the market
increases the prices.
 Expansion of Bank Credit: Rapid expansion of Bank credit is also responsible for
inflation
 Deficit Financing: The high doses of deficit financing, which may cause reckless
spending also, contribute to the growth of inflation.
 Ordinary Monetary Factors:
 High non-development expenditure: Continuous increase on public
expenditure which is non-productive in nature.
 Huge Plan Investment
 Black Money
 High Indirect Taxes
 Non-monetary Factors:
 High Population Growth
 Natural Calamities and Bad Weather Conditions
 Speculation and Hoarding
 High Prices of Interest
 Under-utilization of Resources
3. EFFECTS OF INFLATION
The effects of Inflation on economic system can be categorized in four kinds. They are:
 Effect on Production, i.e. changes in the tempo of economic activity
 Effects of Income Distribution, i.e. redistribution of income and wealth
  Effects on Consumption and Welfare
 Other Economic Effects
3.1 Effects on Production:
Moderate rise in prices, i.e. mild inflation has a favorable effect on production when there are
underutilized resources in an economy. The tempo of economic activity starts raising, but
there is limit to it, Till the level of full employment is reached, moderately rising prices
which is usually harmful are beneficial. But this is true only when the inflation is not a fast
rate.

However there are disastrous consequences which are as follows:

a) Maladjustments: Leads to maladjustments in production and disrupts the

working of pricing system.
b) Hindrance to capital Accumulation: Saving potential of community goes down
as the purchasing power of money declines.
c) Speculation, Hoarding and Black Marketing: Due to inflation and rapidly
rising of prices encourages hoarding and black marketing to make maximum
profit,
d) Creation of sellers’ Market: The market prices are controlled by sellers because
of excessive demand in market. Anything can be sold in such market and sellers
don’t care for the quality of the product.
e) Distortion of Resource Allocation: Inflation will turn away resource allocation
from longer term productive investment and towards unproductive assets like
housing gold reserves etc.
3.2 Distributional Effects:

Inflation redistributes income because prices of all factors do not rise in the same proportion.
Since the effect of inflation on the income of different classes of earners varies, there are
serious social consequences.

Generally debtors gain and creditors loose during inflation, this is because the value of
money goes down during inflation. Inflation is welcomed by entrepreneurs and businessmen
as they stand to profit by raising prices. Also the value of then inventories and stock of goods
 rises in money terms. Salaried people are struck hard by inflation. Farmers usually gain
during inflation because they can get better prices for their harvest during inflation. So it is
very important that when is the inflation hitting the market with respect of crop harvesting.

3.3 Effects on Consumption and Welfare

Inflation implies an erosion of the consumer’s value of money. It is a form of taxation. Due
to deteriorating purchasing power, the real consumption of the common people declines.
Rising cost of living implies falling standard of living standard of living and lowering of
general economic welfare of the community at large.

3.4 Other Economic Effects

Inflation may lead to many adverse consequences as follows:

a) Deterioration in savings
b) Distortion of Budget
c) Disturbance in Planning
d) Lowering of International competition
e) Distortion of the Exchange Rates

4. CONTROL OF INFLATION

There are a number of methods that have been suggested to control inflation. Central banks can affect
inflation to a significant extent through setting interest rates and through other operations. High interest
rates and slow growth of the money supply are the traditional ways through which central banks fight or
prevent inflation. Inflation can be controlled by following means:

a) Fiscal Policy
b) Monetary Policy
c) Supply Management

5. MONETARY POLICY
Monetary policy is the process by which the monetary authority of a country controls the supply
of money, often targeting a rate of interest for the purpose of promoting economic growth and
stability. It is primarily concerned with the management of supply of money in a growing
economy and managing the rate of growth of money supply per period. The optimal Monetary
Policy requires that this rate of growth, on an average, is such as to be consistent with the
attunement of the desires social goals.

Keynesians emphasize reducing aggregate demand during economic expansions and increasing

demand during recessions to keep inflation stable. A low positive inflation is usually targeted, as
deflationary conditions are seen as dangerous for the health of the economy.

Monetary policy regulates the supply of money and the cost and availability of credit in the
economy. It deals with both the lending and borrowing rates of interest for commercial banks.
This policy aims to maintain price stability, full employment and economic growth. The RBI is
responsible for formulating and implementing monetary policy. It can increase or decrease the
supply of currency, increase or decrease the interest rates, carry out Open Market Operation,
control credit and vary the reserve requirements

6. TOOLS OF MONETARY POLICY

a) Open Market Operation: It is the buying and selling of securities by a central bank
in the market in order to increase or decrease the outstanding supply of money. If the
banking system as a whole has extra reserves, it will seek to buy such instruments,
when available, as these are interest bearing instruments. The result will be the
reduction in the interest rate. During inflation, RBI sells securities to mop up the
excess money in the market. Similarly, to increase the supply of money, RBI
purchases securities.

b) Reserve Requirements (CRR and SLR): A reserve requirement is a percentage

indicating how much a bank needs to hold in reserves against its outstanding deposits.
CRR, i.e. Cash Reserve Ratio refers to a portion of the deposit which the banks have
to keep with RBI. It ensures that a portion of bank deposit is totally risk free and also
allows RBI to control liquidity in the system and hence inflation. As CRR increase
money supply in market decreases and hence inflation can be controlled.
 Banks also need to invest a portion of their deposit in Government securities as a part
of their Statutory Liquidity Ratio (SLR). Government Securities are long term in
nature but they are liquid as they can be traded in secondary market.

c) Repo Rates: It is the interest rate at which one bank gives loan to other banks against
government securities. This rate also determines the rate at which banks will lend
money to its consumers which in turn shall increase or decrease the supply of money.

d) Lending by Central Bank at Bank Rate: Bank Rate is the minimum rate at which
the RBI provides loan to the commercial banks. An increment in the bank rate results
in commercial banks increasing their lending rates. This will in turn shall also tend to
affect the price of financial assets, such as bonds and shares. These changes in
financial market affect the consumer and business demand and in turn output.
Changes in the demand and output then, have an impact on labour market,
employment level and wage costs, which in turn influence the producer and consumer
price, rise of which is called inflation.

Thus RBI mainly controls the supply and the cost of the money to control the inflation using
monetary policy.