Inflation

 A general price increase across the entire economy is called inflation . When prices decrease, there is deflation .
Economists measure these changes in prices with price indexes . Inflation can occur when an economy becomes
overheated and grows too quickly. Similarly, a declining economy can lead to deflation.
 Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output.
Central bankers try to stabilize prices to protect economies from the negative consequences of price changes.

Causes of Inflation :
Demand Pull Inflation :
 Increase in money supply
 Increase in disposable income
 Increase in population of the country
 Cost Push Inflation
(When price of input rises)

Low Increase in Supply :

 Obsolete technology
 Deficient machinery
 Scarcity of resources
 Natural Calamities
 Industrial disputes
 Built In Inflation (results from past events and persists )

Types of Inflation :
 Creeping Inflation: This is also known as mild inflation or moderate inflation. This type of inflation occurs when the price
level persistently rises over a period of time at a mild rate. When the rate of inflation is less than 10 per cent annually,
or it is a single digit inflation rate, it is considered to be a moderate inflation.
 Galloping Inflation: If mild inflation is not checked and if it is uncontrollable, it may assume the character of galloping
inflation. Inflation in the double or triple digit range of 20, 100 or 200 percent a year is called galloping inflation . Many
Latin American countries such as Argentina, Brazil had inflation rates of 50 to 700 percent per year in the 1970s and
1980s.
 Hyperinflation: It is a stage of very high rate of inflation. While economies seem to survive under galloping inflation, a
third and deadly strain takes hold when the cancer of hyperinflation strikes. Nothing good can be said about a market
economy in which prices are rising a million or even a trillion percent per year . Hyperinflation occurs when the prices
go out of control and the monetary authorities are unable to impose any check on it. Germany had witnessed
hyperinflation in 1920’s.
 Stagflation: It is an economic situation in which inflation and economic stagnation or recession occur simultaneously
and remain unchecked for a period of time. Stagflation was witnessed by developed countries in 1970s, when world oil
prices rose dramatically.
 Deflation: Deflation is the reverse of inflation. It refers to a sustained decline in the price level of goods and services. It
occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the
real value of money. Japan suffered from deflation for almost a decade in 1990s.

Effects of Inflation on economy

As we know Inflation is the increase in the price of general goods and service. Thus, food, commodities and other
services become expensive for consumption. Inflation can cause both short-term and long-term damages to the economy; most
importantly it causes slow down in the economy.

1. People start consuming or buying less of these goods and services as their income is limited. This leads to slowdown not only
in consumption but also production. This is because manufactures will produce fewer goods due to high costs and anticipated
lower demand.

2. Banks will increase interest rates as inflation increases . This makes borrowing costly for both consumers and corporate. Thus
people will buy fewer automobiles, houses and other goods. Industries will not borrow money from banks to invest in capacity
expansion because borrowing rates are high.

3. Higher interest rates lead to slowdown in the economy. This leads to increase in unemployment because companies start
focusing on cost cutting and reduces hiring. Remember Jet Airways lay off over 1000 employees to save cost.

4. Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can
help fuel inflation.
 5. Inflation affects the productivity of companies. They add inefficiencies in the market, and make it difficult for companies to
budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from
products and services in order to focus on profit and losses from currency inflation.

How to Control Inflation :

There are broadly two ways of controlling inflation in an economy –
Monetary measures and fiscal measures.
1). Monetary measures and
2). Fiscal measures
I).Monetary Measures- The most important and commonly used method to control inflation is monetary policy of the Central
Bank. Most central banks use high interest rates as the traditional way to fight or prevent inflation.
Monetary measures used to control inflation include:
1)Bank rate policy is used as the main instrument of monetary control during the period of inflation. When the central bank
raises the bank rate, it is said to have adopted a dear money policy. The increase in bank rate increases the cost of borrowing
which reduces commercial banks borrowing from the central bank. Consequently, the flow of money from the commercial banks
to the public gets reduced. Therefore, inflation is controlled to the extent it is caused by the bank credit.
 Cash Reserve Ratio (CRR) : To control inflation, the central bank raises the CRR which reduces the lending capacity of
the commercial banks. Consequently, flow of money from commercial banks to public decreases. In the process, it halts
the rise in prices to the extent it is caused by banks credits to the public.
 Open Market Operations: Open market operations refer to sale and purchase of government securities and bonds by
the central bank. To control inflation, central bank sells the government securities to the public through the banks. This
results in transfer of a part of bank deposits to central bank account and reduces credit creation capacity of the
commercial banks.
II). Fiscal Measures- Fiscal measures to control inflation include taxation, government expenditure and public borrowings. The
government can also take some protectionist measures (such as banning the export of essential items such as pulses, cereals
and oils to support the domestic consumption, encourage imports by lowering duties on import items etc.).

Deflation is a contraction in the supply of circulated money within an economy, and therefore the opposite of inflation. In times
of deflation, the purchasing power of currency and wages are higher than they otherwise would have been. This is distinct from
but similar to price deflation, which is a general decrease in the price level, though the two terms are often mistaken for each
other and used interchangeably.
In effect, deflation causes the nominal costs of capital, labor, goods and services to be lower than if the money supply did not
shrink. While price deflation is often a side effect of monetary deflation, this is not always the case.

Causes of Deflation
By definition, monetary deflation can only be caused by a decrease in the supply of money or financial instruments redeemable
in money. In modern times, the money supply is most influenced by central banks, such as the Federal Reserve. Periods of
deflation most commonly occur after long periods of artificial monetary expansion.
There are two principle causes of price deflation. The first is a general increase in the demand for cash savings by consumers and
businesses. This could be because consumers are uncertain, or because their time preferences for consumption have
lengthened. The second cause is a general increase in economic productivity, which grows the supply of goods and boosts the
purchasing power of incomes.
Price deflation through increased productivity is different in specific industries. Consider the technology sector, for example. In
1980, the average cost per gigabyte of data was $437,500; by 2010, the average gigabyte cost 3 cents. The decline of the price of
advanced technology greatly increasing the standard of living around the world.

Deflation Changes Debt and Equity Financing

Deflation makes it less economical for governments, businesses and consumers to use debt financing. However, deflation
increases the economic power of savings-based equity financing.
From an investor's point of view, companies that accumulate large cash reserves or that have relatively little debt are more
attractive under deflation. The opposite is true of highly indebted businesses with little cash holdings. Deflation also encourages
rising yields and increases the necessary risk premium on securities.

Disinflation'
Disinflation is a slowing in the rate of price inflation. It 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, which can be harmful to the economy.
Disinflation is commonly used by the Federal Reserve to describe a period of slowing inflation. Unlike inflation and deflation,
which refer to the direction of prices, disinflation refers to the rate of change in the rate of inflation. Although sometimes
confused with deflation, disinflation is not considered as problematic because prices do not actually drop, and disinflation does
not usually signal the onset of a slowing economy. Deflation is represented as a negative growth rate, such as -1%, while
disinflation is shown as a change in the inflation rate from 3% one year to 2% the next.

Difference between deflation and disinflation

Deflation is a decrease in general price levels of throughout an economy. If there is a higher supply of goods and services but
there is not enough money supply to combat this, deflation can occur. Deflation is mainly caused by shifts in supply and demand.
For example, cellphones have significantly dropped in price since the 1980s due to technological advances that have allowed
supply to increase at a faster rate than the money supply or demand of cellphones.

Disinflation, on the other hand, shows the rate of change of inflation over time. The inflation rate is declining over time, but it
remains positive. For example, if the inflation rate in the United States was 5% in January but decreases to 4% in March, it is said
to be experiencing disinflation in the first quarter of the year.
Price levels can be examined using the consumer price index (CPI), which measures the changes in the price levels of a basket of
goods and services. They can also be measured using the gross domestic product deflator, which measures the price inflation.
Inflation rates can be calculated using CPI data. For example, the CPI in January 1980 to January 1983 was 77.8, 87.0, 94.3 and
97.8, respectively. The inflation rate can be calculated using this formula:
(most recent CPI number - older CPI number) ÷ (older CPI number)
Using the data from above, the inflation rate from January 1980 to January 1981 was 11.83%, and from January 1981 to January
1982 it was 8.4%, showing that this was a period of disinflation because there was a decrease in the inflation rates.

Stagflation'
A condition of slow economic growth and relatively high unemployment – economic stagnation – accompanied by rising prices,
or inflation, or inflation and a decline in Gross Domestic Product (GDP). Stagflation is an economic problem defined in equal
parts by its rarity and by the lack of consensus among academics on how exactly it comes to pass.
Usually, when unemployment is high, spending declines, as do prices of goods. Stagflation occurs when the prices of goods rise
while unemployment increases and spending declines. Stagflation can prove to be a particularly tough problem for governments
to deal with due to the fact that most policies designed to lower inflation tend to make it tougher for the unemployed, and
policies designed to ease unemployment raise inflation.

This happened in the United States during the 1970s when world oil prices rose dramatically, increasing the costs of goods and
contributing to a increase in unemployment. The following stagnation increased the inflationary effects on the economy. Since
the crisis in the 1970s, there has been little consensus on what exactly caused the economic problem. Each school of economics
offers their own understanding on what exactly went wrong and why

Market : An actual or nominal place where forces of demand and supply operate, and where buyers and sellers interact
(directly or through intermediaries) to trade goods, services, or contracts or instruments, for money or barter.
Markets include mechanisms or means for
(1) determining price of the traded item,
(2) communicating the price information,
(3) facilitating deals and transactions, and
(4) effecting distribution.
The market for a particular item is made up of existing and potential customers who need it and have the ability and
willingness to pay for it.

Money Market
There are two types of financial markets viz., the money market and the capital market. The money market in that part of a
financial market which deals in the borrowing and lending of short term loans generally for a period of less than or equal to 365
days. It is a mechanism to clear short term monetary transactions in an economy.
According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; it meets the
short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus
investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising
institutions and individuals and also by the government."
Functions of Money Market
 To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money for short
term monetary transactions.
 To promote economic growth. Money market can do this by making funds available to various units in the economy
such as agriculture, small scale industries, etc.
 To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly it also
provides facility of discounting bills of exchange for trade and industry.
 To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the monetary
policy.
 To help in Capital Formation. Money market makes available investment avenues for short term period. It helps in
generating savings and investments in the economy.
 Money market provides non-inflationary sources of finance to government. It is possible by issuing treasury bills in
order to raise short loans. However this dose not leads to increases in the prices.

Money Market Instruments :

 Treasury Bills (T-Bills): Treasury Bills are one of the safest money market instruments as they are issued by Central
Government. They are zero-risk instruments, and hence returns are not that attractive. T-Bills are cir culated by both
primary as well as the secondary markets. They come with the maturities of 3-month, 6-month and 1-year. The Central
Government issues T-Bills at a price less than their face value and the difference between the buy price and the
maturity value is the interest earned by the buyer of the instrument.
 Certificate of Deposits (CDs): Certificate of Deposit is like a promissory note issued by a bank in form of a certificate
entitling the bearer to receive interest. It is similar to bank term deposit account. The certificate bears the maturity
date, fixed rate of interest and the value. These certificates are available in the tenure of 3 months to 5 years. The
returns on certificate of deposits are higher than T-Bills because they carry higher level of risk.
 Commercial Papers (CPs): Commercial Paper is the short term unsecured promissory note issued by corporate and
financial institutions at a discounted value on face value. They come with fixed maturity period ranging from 1 day to
270 days. These are issued for the purpose of financing of accounts receivables (debtors), inventories and meeting
short term liabilities. The return on commercial papers is higher as compared to T-Bills so as the risk as they are less
secure in comparison to these bills.
 Repurchase Agreements (Repo): Repurchase Agreements which are also called as Repo or Reverse Repo are short term
loans that buyers and sellers agree upon for selling and repurchasing. Repo or Reverse Repo transactions can be done
only between the parties approved by RBI and allowed only between RBI-approved securities such as state and central
government securities, T-Bills, PSU bonds and corporate bonds. They are usually used for overnight borrowing.
Repurchase agreements are sold by sellers with a promise of purchasing them back at a given price and on a given date
in future. On the flip side, the buyer will also purchase the securities and other instruments with a promise of selling
them back to the seller.
 Banker's Acceptance: Banker's Acceptance is like a short term investment plan created by non-financial firm, backed by
a guarantee from the bank. It's like a bill of exchange stating a buyer's promise to pay to the seller a certain specified
amount at a certain date. And, the bank guarantees that the buyer will pay the seller at a future date. Firm with strong
credit rating can draw such bill. These securities come with the maturities between 30 and 180 days and the most
common term for these instruments is 90 days. Companies use these negotiable time drafts to finance imports, exports
and other trade

Capital Market:
Broadly speaking the capital market is a market for financial assets which have a long or indefinite maturity. Unlike money
market instruments the capital market instruments become mature for the period above one year. It is an institutional
arrangement to borrow and lend money for a longer period of time.
It consists of financial institutions like IDBI, ICICI, UTI, LIC, etc. These institutions play the role of lenders in the capital market.
Business units and corporate are the borrowers in the capital market. Capital market involves various instruments which can be
used for financial transactions. Capital market provides long term debt and equity finance for the government and the corporate
sector. Capital market can be classified into primary and secondary markets. The primary market is a market for new shares,
where as in the secondary market the existing securities are traded. Capital market institutions provide rupee loans, foreign
exchange loans, consultancy services and .
Money Market Instruments provide the tools by which one can operate in the money market. Money market instrument meets
short term requirements of the borrowers and provides liquidity to the lenders. The most common money market instruments
are Treasury Bills, Certificate of Deposits, Commercial Papers, Repurchase Agreements and Banker's Acceptance.

Index numbers
An index number is an economic data figure reflecting price or quantity compared with a standard or base value. The base usually equals 100
and the index number is usually expressed as 100 times the ratio to the base value. For example, if a commodity costs twice as much in 1970 as
it did in 1960, its index number would be 200 relative to 1960. Index numbers are used especially to compare business activity, the cost of
living, and employment. They enable economists to reduce unwieldy business data into easily understood terms.

In economics, index numbers generally are time series summarizing movements in a group of related variables. In some cases, however, index
numbers may compare geographic areas at a point in time. An example is a country's purchasing power parity. The best-known index number is
the consumer price index, which measures changes in retail prices paid by consumers. In addition, a cost-of-living index (COLI) is a price index
number that measures relative cost of living over time. In contrast to a COLI based on the true but unknown utility function, a superlative index
number is an index number that can be calculated. Thus, superlative index numbers are used to provide a fairly close approximation to the
underlying cost-of-living index number in a wide range of circumstances.

There is a substantial body of economic analysis concerning the construction of index numbers, desirable properties of index numbers and the
relationship between index numbers and economic theory.
A number indicating change in magnitude, as of price, wage, employment, or production shifts, relative to the magnitude at a specified point
usually taken as 100.

Devaluation'
Devaluation is a deliberate downward adjustment to the value of a country's currency relative to another currency, group of currencies or
standard. Devaluation is a monetary policy tool used by countries that have a fixed exchange rate or semi-fixed exchange rate. It is often
confused with depreciation, and is the opposite of revaluation.

Devaluing a currency is decided by the government issuing the currency, and unlike depreciation, is not the result of non-governmental
activities. One reason a country may devaluate its currency is to combat trade imbalances. Devaluation causes a country's exports to become less
expensive, making them more competitive in the global market. This, in turn, means that imports are more expensive, making domestic
consumers less likely to purchase them, further strengthening domestic businesses.

While devaluating a currency can seem like an attractive option, it can have negative consequences. By making imports more expensive, for
example, it protects domestic industries who may then become less efficient without the pressure of competition. Higher exports relative to
imports can also increase aggregate demand, which can lead to inflation.

Examples of Devaluation
The devaluation of currencies arises in many situations, but comes about due to specific government action. For example, Egypt has faced
constant pressure from a black market for U.S. dollars (USD). The rise of the black market came about due to a foreign currency shortage that
hurt domestic businesses and discouraged investments within the economy. To stop the black market activity, the central bank devalued the
Egyptian pound in March 2106 by 14% when compared to the USD.

The Egyptian stock market responded favorably when the currency was devalued. However, the black market responded by depreciating the
exchange rate of USD to the Egyptian pound, forcing the central bank to take further action. As of July 12, 2016, it's expected that the central
bank will devalue its currency again. The stock market reacted favorably to the news, rallying on July 12, and subsequently declining slightly on
July 13 when bankers said that no devaluation would occur for the week.

Using another example, China has been accused of practicing a quiet devaluation of its currency in 2016 to prepare for the results of the
presidential elections in November 2016. This is due to the fact that both candidates, Hillary Clinton and Donald Trump, have spoken out against
China. It would do well for the country to strengthen the Yuan versus the USD to repair economic relationships with the United States. Some
believe that the country is secretly devaluing its currency so that it can revalue it after the November election, making it look like it is
cooperating

Value of Money: Meaning, Measurement and Preparation of Index Numbers

Value, as we know, is the ratio of exchange between two goods, and money measures that value through price. Money is an object of desire.
Efforts are made to obtain it not for its own sake but for the goods it can purchase.

The value of money, then, is the quantity of goods in general that will be exchanged for one unit of money. The value of money is its purchasing
power, i.e., the quantity of goods and services it can purchase. What money can buy depends on the level of prices. When the price level rises, a
unit of money can purchase less goods than before. Money is then said to have depreciated. Conversely, a fall in prices signifies that a unit of
money can buy more than before.

Money is then said to appreciate. The “general level of prices” and the value of money are thus the same thing from two opposite angles. When
the prices rise the value of money falls and vice versa. In other words, the value of money and the general price level are inversely proportion s’
to each other. Violent changes in the value of money (or the price level) disturb economic life and do great harm. We must, therefore, carefully
study the factors which’ determine the value of money.

Suppose we have found by measurement that a room is four meters long. Measuring it again next day we are surprised to see that the same room
is five meters in length. How could the room stretch itself by a meter overnight? Was some partition knocked out or an extension added during
the night? Or is it that our meter measure has grown shorter by 2 centimeters? Which out of these is the correct answer? In the same way, if a
rupee can buy one kg of wheat today but purchases only half a kg tomorrow, we are greatly perplexed.

We feel disgusted with our food-measure, the rupee, which has shrunk to half its length. We want to know what has happened. We are told “the
value of money has changed.” Exactly this is what has happened in India. There are many times more rupee notes circulating in the country now
than previously, while the number of goods has not increased to that extent. Hence a rupee buys less.

Measurement of Changes in the Value of Money:

Changes in prices are not uniform. Some prices rise, others fall; while still others remain stationary. They are like bees dashing out of a hive
higgledy-higgledy, some buzzing off this way, some that way, while others keep hovering at the spot. But there may be a trend in a particular
direction. A comparison of price changes would give a very confusing picture. We have to discover the extent of the overall changes in the value
of money before suggesting a remedy. The seriousness of the disease must be known before a remedy can be suggested.

Index Numbers:
The device of index numbers comes to our aid in measuring changes in the value of money or price level. An index number is a statement in the
form of a table which represents a change in the general price level. Index numbers have great importance in these days. When it is desired to
find out to what extent prices have risen or fallen, an index number is prepared. In every advanced country, index numbers are being regularly
prepared officially by the governments and also non-officially by other bodies interested in economic changes.

Preparation of Index Numbers:

The following steps are necessary for the preparation of index numbers:
(a) Selection of the Base Year:
The first thing necessary is to select a base year. It is the year with which we wish to compare the present prices, in order to see how much the
prices have risen or fallen. The base year must be a normal year. It should not be a year of famine, or war, or a year of exceptional prosperity.

(b) Selection of Commodities:

The next step is to select the commodities to be included in the index number. The commodities will depend on the purpose for which the index
number is prepared. Suppose we want to know how a particular class of people has been affected by a change in the general price level. In that
case, we should include only those commodities which enter into the consumption of that class.

(c) Collection of Prices:

After commodities have been selected, their prices have to be ascertained. Retail prices are the best for the purpose, because it is at the retail
prices that a commodity is actually consumed. But retail prices differ almost from shop to shop, and there is no proper record of them. Hence we
have to take the wholesale prices of which there is a proper record.

(d) Finding Percentage Change:

The next step is to represent the present prices as the percentages of the base year prices. The base year price is equated to 100, and then the
current year’s price is represented accordingly. This will be clear from the index number given on the next page.

(e) Averaging.

Finally, we take the average of both the base year and the current year figures in order to find out the overall change. In May 1985, the price
index was 355 which means that the price on the average were more than three-and a-half times as much or 255 per cent higher than what they
were in 1970-71.

Uses of Index Numbers:

Index numbers can be used for a number of purposes:

(i) Index numbers are used not merely to measure changes in the price level or changes in the value of money. They can be used to measure
quantitative change. Thus, we can prepare an index number of wages, imports, exports, industrial production, unemployment, profits, area under
cultivation, enrolment in a college, etc.

Foreign Exchange'
Foreign exchange is the exchange of one currency for another or the conversion of one currency into another currency.
Foreign exchange also refers to the global market where currencies are traded virtually around the clock. The largest trading centers are London,
New York, Singapore and Tokyo. The term foreign exchange is usually abbreviated as "forex" and occasionally as "FX."

Foreign exchange transactions encompass everything from the conversion of currencies by a traveler at an airport kiosk to billion-dollar
payments made by corporations, financial institutions and governments. Transactions range from imports and exports to speculative positions
with no underlying goods or services. Increasing globalization has led to a massive increase in the number of foreign exchange transactions in
recent decades.
The global foreign exchange market is the largest financial market in the world, with average daily volumes in the trillions of dollars. Foreign
exchange transactions can be done for spot or forward delivery. There is no centralized market for forex transactions, which are executed over
the counter and around the clock.

8 Key Factors that Affect Foreign Exchange Rates

1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another's will see an
appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a
consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency
and is usually accompanied by higher interest rates

2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in
interest rates cause a country's currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more
foreign capital, which causes a rise in exchange rates

3. Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its
exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale
of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.

4. Government Debt
Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire
foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a
certain country. As a result, a decrease in the value of its exchange rate will follow.

5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country's terms of trade
improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This results in an appreciation of exchange rate.

6. Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more
attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in
foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not
give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.

7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its
currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a
result, the value of the currency will rise due to the increase in demand. With this increase in currency value comes a rise in the exchange rate as
well.

Conclusion:
All of these factors determine the foreign exchange rate fluctuations. If you send or receive money frequently, being up-to-date on these factors
will help you better evaluate the optimal time for international money transfer. To avoid any potential falls in currency exchange rates, opt for a
locked-in exchange rate service, which will guarantee that your currency is exchanged at the same rate despite any factors that influence an
unfavorable fluctuation.

CREDIT INSTRUMENTS:
Credit Instruments are the documents describing details of credit and debit. Credit Instruments provide a written means from future
reference describing terms and conditions of any debt and loan. Credit Instruments may be an order for payment of money to a specified person
or it may be a promise to pay the loan. Credit Instruments generally in use are cheques, bills of exchanges, bank overdraft etc.

Let us study the main types of credit instruments.

Promissory Note:
The simplest form of a credit instrument is the promissory note. A promissory note (or pro-note for short) is a written promise from a buyer or a
borrower to pay a certain sum of money to the creditor or his order. It is what we call IOU (I owe you), i.e., an acknowledgment of debt and an
obligation to repay.
A typical promissory note is as below:

The words “value received” indicates that the document is the result of some purchase or loan. Interest must be mentioned; otherwise the pro-
note is not good in law. Such a document can be used for any kind of transaction, personal or commercial.

Bill of exchange:
A bill of exchange is used in internal as well as foreign trade. It is an order by a seller to a buyer or by a creditor to a debtor to pay a certain sum
of money to himself or to bearer or to another person named therein. The seller or the creditor who draws the bill is called the ‘drawer’; the
purchaser or the debtor on whom the bill is drawn is called the “drawee.” The seller may order the payment to be made to a third person called
the “payee”.

Specimens of inland and foreign bills of exchange are given below:

In place of the payee’s name any of these forms may be used:

ADVERTISEMENTS:
1. Pay to bearer,
2. Pay to Dr. J. D. Varma or order, or
3. Pay to my order.
When the bill of exchange begins with “On demand”, instead of “thirty days”, it is a “demand bill’ or “sight bill’.

The drawer sends ‘he bill to the drawee who “accepts” it by signing it and putting his office stamp on it. The bill now becomes a negotiable
instrument and can be bought and sold in the market. The drawer can now discount it and change it into cash on paying a commission, called
discount, at some firm or bank. It may pass through several hands before it ultimately matures or falls due for payment, when the drawee pays
his debt by honouring the bill.
If the drawee is not very well known, he secures the services of an Accepting House to sign and accept the Bill. Such houses or firms specialize
in providing guarantees and charge a commission for their services. To perform such services the Accepting Houses have to keep themselves
well informed of the financial position of the merchants on whose behalf they accept bills.
Advantages of a bill of exchange:
A bill of exchange thus performs the following important functions:
(i) “Neither the exporter nor the importer has to go without his money while the goods are in transit.—(Sayers) The exporter gets his money
from a bank and the importer does not have to pay immediately. He pays it after he has sold the goods, and has funds in hand.
(ii) Funds lying idle in banks are invested in Bills of Exchange and are profitably employed. Banks particularly favour this form of investment,
because money is not locked up for long and can be withdrawn easily. It is said that a good bank manager knows the difference between a bill
and a mortgage. The bills discounted set up a regular stream of money flowing in and out.
(iii) Gold and silver are saved from being transported between countries. Exports are made to balance against imports through the bill market
without movement of gold.
(iv) While the buyer pays in his own currency, the seller is paid in his own. Exchange Banks undertake the whole work and individuals are saved
from all bother and inconvenience.
Hundis:
We, in India, are more familiar with hundis as they are commonly used. They are internal bills of exchange in one of our own languages, and
have been prevalent in India long before the dawn of civilization elsewhere. Hundis are Darshani (sight bills) and Miadi or Muddati (time bills)
on the basis of the time allowed to the debtor. Hundiana is the commission sometimes deducted by the lender from the amount advanced.
Specimens of the two types of hundis used in India (translated in English) are given below:

Cheques:
Definition:
A cheque is the most common instrument of credit and almost works like money. It is a written order on a printed form by a depositor (drawer)
to his bank to pay a sum of” money to himself or to somebody else, whose name is entered on it, or to the bearer, i.e., the man who holds it (i.e.,
drawee). No bank ordinarily refuses to pay money for a cheque, provided it is correctly filled in, and there is enough money in the drawer’s
account with the bank. A specimen cheque is given below. The counterfoil with the drawer serves as a record of the payment.
Cheques are of the following kinds:

Bearer Cheque:
Any one, who happens to have the cheque, can get it cashed. In this case, the bank need not worry as to who presents it at the counter. If a bearer
cheque is lost, the finder can cash it unless the bank is notified in time to stop the payment. The drawer runs the risk of losing his money, and not
the bank.
Order Cheque:
The word “bearer” after the payee’s name is crossed out, as in the cheque form below, and the word “order” written instead. It is a safer form of
payment, because the bank is responsible for paying the money to the right person. The person who presents the cheque at the counter has to
prove his identity, before the proceeds of the cheque can be paid to him.

Crossed Cheque:
This is the safest form of payment as it cannot be cashed .it the bank counter. The payee cannot get the proceeds of the cheque in cash, lie can
only get the sum transferred to his own or (after endorsing) to somebody else’s account. A cheque is “crossed” by drawing two parallel lines
across its face or in a corner and writing the words “& Co.” between them. The specimen given above is crossed. If it is crossed “Payee’s A/c.”,
then cash cannot be obtained from the bank; the amount of the cheque can only be credited to the payee’s A/c.
Post-dated Cheque:
Such a cheque is a way of making payments sometime in the future. If you have to pay a hundred rupees to a friend after a month, you may draw
a cheque in his favour and put down the future date. It can be cashed only on or after that date.
Blank Cheque:
It means an unlimited offer because the signature is put, whereas the space for the amount is left blank to be filled in by the drawee. Such
cheques are usually handed over in romances or films! Nobody ordinarily signs a blank cheque.
Advantages of Cheques:
The cheque has economized the use of money. No cash need be paid. Moreover, its great convenience lies in that the payment can be exact to a
paisa. There is no fear of loss when the cheque is crossed. Thus it is safe method of payment, besides being convenient. Again, the counterfoil of
the cheque serves as a receipt and, therefore, ensures honesty.
The account of the transaction is with the bank and can be called for evidence, if needed. But it requires confidence in the drawer as well as the
bank for acceptance. Since cheques are not legal tender, their acceptance is not compulsory.
Bank Drafts:
A cheque can also be used to remit funds to another place. But as the account is held in a different place, from where the cheque is presented, the
latter branch of the bank normally gets in touch with the former before making the payment. To avoid this botheration, a banker’s draft is used.
A bank draft is a cheque drawn by a bank on its own branch or on another bank requiring the latter to pay a specified amount to the person
named in it or to the order thereof. The cheapest method of sending money is through a bank draft. A bank does not usually charge more than 10
P. per hundred rupees if the amount to be sent is not less than a thousand rupees, and if it has a branch at the place of payment.

Clearing House:
One great advantage that follows from the use of cheques is that we do not have to carry a pocketful of notes or coins for our purchases. In
countries, where people have developed the banking habit, rarely is a purchase paid for in cash, unless it is a very small sum. The people who are
paid in cheques do not get them cashed but just pay them into their accounts at their bank. Thus, if both the persons have a common bank, a mere
change in their bank balances completes the transaction.
When there are several banks in a locality and the two persons have accounts with different banks, the process is not so simple. Every bank
receives during the course of the day cheques on other banks in favour of its customers. To send cash back and forth from one bank to another
every day would be very troublesome. To avoid this trouble, the device of a Clearing House is used.
The representatives of the local banks meet at a fixed place after the working hours and balance their claims against one another. When simple
book entries have cancelled most of the obligations, a small balance may be claimed by one bank from the other.
This is usually settled through a cheque on the Central bank (the Reserve Bank of India or the State Bank of India) with which all commercial
banks have to keep accounts. There are Clearing Houses in important cities in India, the most important being those in Bomaby, Calcutta and
Delhi.

Advantages of Credit:
(i) Credit instruments replace metallic money to some extent. This means a great economy. Expenditure is avoided on precious metals for
monetary purposes. Also, there is no loss arising from wear and tear of coins.
(ii) Trade and industry are financed mostly by the aid of credit. No industrial or commercial progress would be possible if the business were to
be conducted strictly on a cash basis. In the absence of credit, trade would be on a very restricted scale.
(iii) Credit makes capital more productive. It is through credit that capital is transferred from persons who cannot use it themselves to persons
who are in a position to do so. Without credit facilities, a good deal of capital would have remained unused.
(iv) Credit enables banks to lend far beyond their cash reserves. Thus they are able to make profits for themselves besides helping trade and
industry. The banks can in this way ‘create money’.
(v) Credit instruments like bills of exchange facilitate payments not only between people living in the same country, but also between people
belonging to different countries. This facilitates and extends international trade.
(vi) Men of enterprise and business ability are enabled by credit to launch business undertakings, even though their own financial resources may
be meagre. In this way, credit helps the development of trade and industry in the country. Without its aid, a good deal of business talent would
have been wasted.

Abuses of Credit:
(i) Reckless borrowing ruins both the borrower and the lender. A spirit of gambling is introduced in business. This is against the spiritual healthy
trade.
(ii) By making it easy for a person to get funds, credit may encourage extravagance and waste. People start living beyond their means. This is
indeed a very bad habit.
(iii) If the banks create credit beyond proper limits, it may encourage speculation. Over-speculation may endanger the economic stability of the
country. It stands in the way of healthy development of trade and industry.
(iv) Free use of credit by the manufacturers may lead to over-production, causing depression in the industry. Depression brings business to a
standstill. It causes unemployment and brings misery to the workers.
(v) Unsound businesses are kept alive by the artificial aid of credit. It is in the interest of the community that such weak links should be removed.
Credit may only conceal the financial weakness of a concern.
(vi) Credit encourages the formation of monopolies by placing large funds at the disposal of a few individuals or corporations. Monopolies
exploit consumers and indulge in so many other anti-social practices.

Credit Creation

It is an open secret that the banks do not keep cent per cent reserve against deposits in order to meet the demands of depositors. The bank is not a
cloak room where you can keep your currency notes or coins and claim those very notes or coins back when you desire. It is generally
understood that money received by the bank is meant to be advanced to others. A depositor has to be content simply with the bank’s promise or
undertaking to pay him back whenever he makes a demand.

This bank is able to do with a very small reserve, because all the depositors do not come to withdraw money simultan eously; some withdraw,
while others deposit at the same time. The bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash reserve. The
bank is able to lend money and charge interest without parting with cash. The bank loan creates a deposit or, as we have seen above, it creates a
credit for the borrower.

Similarly, the bank buys securities and pays the seller with its own cheque which again is no cash; it is just a promise to pay cash. The cheque is
deposited in some bank and a deposit is created or credit is created for the seller of the securities. This is credit creation.

Thus, term ‘credit creation’ implies a situation, to use Benham’s words, when “a bank may receive interest simply by permitting customers to
overdraw their accounts or by purchasing securities and paying for them with its own cheques, thus increasing the total bank deposits.”

Limitations on Credit Creation:

From the account of credit creation given above, it would seem that the banks ‘reap where they have not sown’. They advance loans or buy
securities without actually paying cash. But they earn interest on the loans they give, or earn dividends on the securities they purchase, all the
same. This is very tempting. They make profits without investing cash. They would, of course, like to make as much profit, like this, as they can.
But they cannot go on expanding credit indefinitely. In their own interest, they have to apply the brake and they do actually apply it, for it is well
known that the profits made by the banks are not very high. The overriding limitation arises from the obligation-of the banks to meet the
demands of their depositors.

Benham has mentioned three limitations on the powers of the banks to create credit:

(i) The total amount of cash in the country;

(ii) The amount of cash which the public wishes to hold; and

(iii) The minimum percentage of cash to deposits which the banks consider safe.

As for (i), it may be said that credit can be created on the basis of cash. The larger the cash (i.e.. legal tender money), the larger the amount 0f
credit that can- be created. But the amount of cash that a bank may have is such to the control of the Central Bank.

Here it may suffice to say that the Central bank has the monopoly of issuing the cash. It may increase it or decrease it, and expand or contract
accordingly. The power of the central bank to control currency is thus the controlling influence on the extent of credit, that Create.

The second limitation arises from the habit of the people regarding regarding the use of cash. If people are in the habit of using cash and not
cheques, as in India, then as soon as credit is granted by the bank to a borrower, he will draw the cheque and gel cash. When the bank’s cash
reserve is thus reduced, its power to create credit is correspondingly reduced.

On the other hand, if people use cash only for very small and odd transactions, then the cash reserve of the banks is not much drawn upon, and
their power of creating credit remains unimpaired. This is the case in advanced countries like the U.S.A., U.K. and other European countries.
There the banks keep only 4-5 per cent cash reserve.

The third limitation is the most important. It arises from the traditional reserve ratio of cash to liabilities which the banks must maintain to ensure
their own safety and to maintain the degree of liquidity that is considered desirable. It is clear that when a bank creates a credit or grants a loan, it
undertakes a liability.

There is an increase in its liabilities, and there is correspondingly a fall in the reserve ratio. The bank will not let the ratio fall below a certain
minimum. When that minimum is reached, the power of the bank to create credit comes to an end. To grant any further credit will be risky
unless the bank’s experience is reassuring enough to permit the adoption of a lower percentage. Then that would become the limit.

To these may be added the fourth limitation: The bank cannot create credit without acquiring assets (in this case the borrower’s promise to pay
or some security). An asset is a form of wealth. Thus the bank only turns immobile wealth into mobile wealth. Hence, as Crowther observes,
“the bank does not create money out of thin air, it transmutes other forms of wealth into money.”

To sum up: The essential conditions for the creation of credit are that the banks obtain fresh cash reserves, they should be willing to lend and the
businessmen should be willing to borrow, and the borrowers should not withdraw the amount of the loan, but be content to leave it in the form of
deposits with the bank. The initiative is in the hands of the borrowers. The deposit is, in fact, created not by the amount borrowed, but by the
amount not withdrawn.