B V M Engineering College

Vallabh Vidyanagar

NAME OF FACULTY : Dr. Manisha Bhatt

CLASS : 2nd Year B. Tech

SEMESTER : III SEM

SUBJECT CODE : 2HSO2

SUBJECT : Economics and Management for Engineers

UNIT-1 Economics, Market

 Inflation: Types of Inflation, measures to control inflation. Fiscal

and monetary policy.

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 What is Inflation?
Inflation is a constant rise in the general level of prices of goods and
services in an economy over a period of time without a corresponding
increase in the level of aggregate output. Its generate s a pressure on
aggregate supply thus causing a rise in price
When the general price level rises, each unit of currency buys fewer goods
and services. Therefore, inflation also reflects an erosion of purchasing
power of money.
It is not high prices but rising price level that constitute inflation. It
constitutes, thus, an overall increase in price level. It can, thus, be viewed
as the devaluing of the worth of money. In other words, inflation reduces
the purchasing power of money. A unit of money now buys less. Inflation
can also be seen as a recurring phenomenon
The important characteristics of inflation:
1. Inflation is always associated with a rise in prices which is continuous
and persistent.
2. Inflation is a dynamic process which can be observed over the long period.
3. Inflation is basically an economic phenomenon. It originates within the
economic system and is fostered by interaction of economic forces.
4. Excess of demand over the available supply is the hall mark of inflation.
It is a condition of economic disequilibrium.
5. Inflation is generally considered a monetary phenomenon for it is
normally characterized by an excessive money supply. Though all
increases in the stock of money may not be inflationary yet a persistent
rise in prices cannot be sustained unless the quantity of money rises as
well.
6. Inflation may be caused by ‘demand-pull’ factors or ‘cost push’ factors
or both working together.

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 Reasons of Inflation
• Increase in Money supply
• Increase in effective demand
• Decreased effective supply or aggregate output
Types of Inflation-The main two types of inflation
1. Demand-pull inflation –

sThis occurs when the economy grows quickly and starts to ‘overheat’ –
Aggregate demand (AD) will be increasing faster than aggregate supply
(LRAS). This occurs when AD increases at a faster rate than AS. Demand pull
inflation will typically occur when the economy is growing faster than the
long run trend rate of growth. If demand exceeds supply, firms will respond
by pushing up prices.
Demand pull inflation can be defined as a type of inflation that occurs
when price level increases due to a greater demand for goods or services
than there is supply available.
In other words, Demand-pull inflation occurs when aggregate demand for
goods or services outstrips aggregate supply. These constituents of the
economy demand more goods than can be produced by the economy.
When supply cannot rise to meet demand, sellers will increase prices,
thereby causing inflation.
2. Cost push inflation
this occurs when there is a rise in the price of raw materials, higher taxes,
e.t.c Demand Pull Inflation Cost-push inflation is a type of inflation that
occurs when higher production costs (increase in the cost of wages, raw
materials etc.) push up the prices of goods and services.
The increased price of the factors of production leads to a decreased
supply of these goods. While the demand remains constant, the prices of
commodities increase causing a rise in the overall price level. For ex. Gas,
Petrol price. This occurs when there is an increase in the cost of
production for firms causing aggregate supply to shift to the left. Cost-
push inflation could be caused by rising energy and commodity prices.
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Measures to control inflation. Fiscal and monetary policy.

1. Monetary Measures:

The government of a country takes several measures and formulates policies to

control economic activities. Monetary policy is one of the most commonly used
measures taken by the government to control inflation
1. CRR- Changes in Reserve Ratios:
Under this method, CRR and SLR are two main deposit ratios, which reduce or
increases the idle cash balance of the commercial banks. Every bank is required
by law to keep a certain percentage of its total deposits in the form of a reserve
fund in its vaults and also a certain percentage with the central bank.
When prices are rising, the central bank raises the reserve ratio. Banks are
required to keep more with the central bank. Their reserves are reduced and they
lend less. The volume of investment, output and employment are adversely
affected. In the opposite case, when the reserve ratio is lowered, the reserves of
commercial banks are raised. They lend more and the economic activity is
favorably affected.

2. SLR-Statutory Liquidity Ratio is essentially a control measure; it refers to the

amount a commercial bank must keep in the form of gold or securities before
providing loans to consumers. In case of a lower SLR, the banks have higher
amount to give as credit which means that more people will now take loans for
various purposes.
Since credit becomes available at a lower rate of interest and puts money in the
hand of the people, the demand for goods rises. This may lead to inflation, when
people have more cash in their hands than the goods produced in the market.
Similarly, in case of a higher SLR, banks have less money to lend, they will now
lend at a higher rate of interest. This helps in curbing inflation. But it also slows
down the economy.
In case of inflation in the economy the RBI uses SLR as a means to suck liquidity
from the market. When the banks have less money to deploy as loans they will
increase the interest rates to maintain their profit margin.

As loans become expensive the consumers borrow less and spend less. Thus the
demand falls, prices start falling and so does inflation
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3-BRR- Rise in Bank Rate:
Refers to one of the most widely used measure taken by the central bank to
control inflation. The bank rate is the rate at which the commercial bank gets a
rediscount on loans and advances by the central bank. The increase in the bank
rate results in the rise of rate of interest on loans for the public.
This leads to the reduction in total spending of individuals.

4-OMO- Open Market Operations Refers to one of the important method used by
the central bank to reduce the credit creation capacity of commercial banks. The
central bank issues government securities to commercial banks and certain
private businesses. In this way, the cash with commercial banks would be spent
on purchasing government securities. As a result, commercial bank would reduce
credit supply for the general public.

5-SCC-. Selective Credit Controls:

Selective credit controls are used to influence specific types of credit for particular
purposes. They usually take the form of changing margin requirements to control
speculative activities within the economy. When there is risk speculative activity
in the economy or in particular sectors in certain commodities and prices start
rising, the central bank raises the margin requirement on them.

2. Fiscal Measures:
Apart from monetary policy, the government also uses fiscal measures to control
inflation. Measures

• 1. Reduction of Govt. Expenditure • 2. Increase in Taxation

• 3. Imposition of new Taxes • 4. Wage Control
• 5. Maintaining Surplus Budget • 6. Public Debt
• 7. Increase in savings • 8. Rationing
1. Increase in Imports of Raw materials 2. Decrease in Exports
3. Increase in Productivity 4. Provision of Subsidies
5. Use of Latest Technology 6. Rational Industrial Policy

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(a)Reduction in Unnecessary Expenditure:
The government should reduce unnecessary expenditure on non-development
activities in order to curb inflation. This will also put a check on private
expenditure which is dependent upon government demand for goods and
services. But it is not easy to cut government expenditure. Though this measure is
always welcome but it becomes difficult to distinguish between essential and
non-essential expenditure. Therefore, this measure should be supplemented by
taxation.

(b) Increase in Taxes:

To cut personal consumption expenditure, the rates of personal, corporate and
commodity taxes should be raised and even new taxes should be levied, but the
rates of taxes should not be so high as to discourage saving, investment and
production. Rather, the tax system should provide larger incentives to those who
save, invest and produce more.

Further, to bring more revenue into the tax-net, the government should penalise
the tax evaders by imposing heavy fines. Such measures are bound to be effective
in controlling inflation. To increase the supply of goods within the country, the
government should reduce import duties and increase export duties.

(c) Increase in Savings:

Another measure is to increase savings on the part of the people. This will tend to
reduce disposable income with the people, and hence personal consumption
expenditure. But due to the rising cost of living, people are not in a position to
save much voluntarily.

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For this purpose, the government should float public loans carrying high rates of
interest, start saving schemes with prize money, or lottery for long periods, etc. It
should also introduce compulsory provident fund, provident fund-cum-pension
schemes, etc. All such measures increase savings and are likely to be effective in
controlling inflation.

(d) Surplus Budgets:

An important measure is to adopt anti-inflationary budgetary policy. For this
purpose, the government should give up deficit financing and instead have
surplus budgets. It means collecting more in revenues and spending less.

(e) Public Debt:

At the same time, it should stop repayment of public debt and postpone it to
some future date till inflationary pressures are controlled within the economy.
Instead, the government should borrow more to reduce money supply with the
public.Like monetary measures, fiscal measures alone cannot help in controlling
inflation. They should be supplemented by monetary, non-monetary and non-
fiscal measures.

3. Other Measures:
The other types of measures are those which aim at increasing aggregate supply
and reducing aggregate demand directly.

(a) To Increase Production:

The following measures should be adopted to increase production:
(i) One of the foremost measures to control inflation is to increase the production
of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable
oils, etc.

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(ii) If there is need, raw materials for such products may be imported on
preferential basis to increase the production of essential commodities,

(iii) Efforts should also be made to increase productivity. For this purpose,
industrial peace should be maintained through agreements with trade unions,
binding them not to resort to strikes for some time,

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy. Under
hyperinflation, there is a wage-price spiral. To control this, the government
should freeze wages, incomes, profits, dividends, bonus, etc.But such a drastic
measure can only be adopted for a short period as it is likely to affect both
workers and industrialists.

(c) Price Control:

Price control and rationing is another measure of direct control to check inflation.
Price control means fixing an upper limit for the prices of essential consumer
goods. They are the maximum prices fixed by law and anybody charging more
than these prices is punished by law. But it is difficult to administer price control.

(d) Rationing:
Rationing aims at distributing consumption of scarce goods so as to make them
available to a large number of consumers. It is applied to essential consumer
goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise the
prices of necessaries and assure distributive justice. But it is very inconvenient for
consumers because it leads to queues, artificial shortages, corruption and black
marketing. Inflation is like a hydra- headed monster which should be fought by
using all the weapons at the command of the government.

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The two main components of fiscal policy are government revenue and
government expenditure. In fiscal policy, the government controls inflation either
by reducing private spending or by decreasing government expenditure, or by
using both. It reduces private spending by increasing taxes on private businesses.
When private spending is more, the government reduces its expenditure to
control inflation. However, in present scenario, reducing government expenditure
is not possible because there may be certain on-going projects for social welfare
that cannot be postponed.
Besides this, the government expenditures are essential for other areas, such as
defense, health, education, and law and order. In such a case, reducing private
spending is more preferable rather than decreasing government expenditure.
When the government reduces private spending by increasing taxes, individuals
decrease their total expenditure.
For example, if direct taxes on profits increase, the total disposable income would
reduce. As a result, the total spending of individuals decreases, which, in turn,
reduces money supply in the market. Therefore, at the time of inflation, the
government reduces its expenditure and increases taxes for dropping private
spending.

DISCLAIMER

This study Material is

Compiled by Dr. Manisha Bhatt. The basic objective of this material is to
provide extra reading and learning to students so as to enable to obtain clear
concept of the subject. Students should also supplement their study by
reference to the books recommended by B V M Engineering College-AN
AUTONOMUS INSTITUTION

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