Lecture Notes- Macroeconomics

8/8/2019 Lecture Notes- Macroeconomics

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A 2 M a c r o e c o n o m i c s / I n t e r n a t i o n a l E c o n o m yFiscal Policy Effects Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of individual households and businesses hence in this note we consider some of themicroeconomic effects of fiscal policy before considering the links between fiscal policy and aggregate demand and key macroeconomic objectives.The microeconomic effects of fiscal policyTaxation and work incentivesCan changes in income taxes affect the incentive to work? This remains a controversial subjectin the economic literature!Consider the impact of an increase in the basic rate of income tax or an increase in the rate of national insurance contributions. The rise in direct tax has the effect of reducing the post-taxincome of those in work because for each hour of work taken the total net income is nowlower. This might encourage the individual to work more hours to maintain his/her targetincome. Conversely, the effect might be to encourage less work since the higher tax might actas a disincentive to work. Of course many workers have little flexibility in the hours that theywork. They will be contracted to work a certain number of hours, and changes in direct taxrates will not alter that.The government has introduced a lower starting rate of income tax for lower income earners.This is designed to provide an incentive for people to work extra hours and keep more of whatthey earn.Changes to the tax and benefit system also seek to reduce the risk of the poverty trap where households on low incomes see little net financial benefit from supplying extra hours of their labour. If tax and benefit reforms can improve incentives and lead to an increase in thelabour supply, this will help to reduce the equilibrium rate of unemployment (the NAIRU) and

thereby increase the economys non-inflationary growth rate.Taxation and the Pattern of Demand


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Changes to indirect taxes in particular can have an effect on the pattern of demand for goodsand services. For example, the rising value of duty on cigarettes and alcohol is designed to

cause a substitution effect among consumers and thereby reduce the demand for what areperceived as de-merit goods . In contrast, a government financial subsidy to producers hasthe effect of reducing their costs of production, lowering the market price and encouraging anexpansion of demand.The use of indirect taxation and subsidies is often justified on the grounds of instancesof market failure . But there might also be a justification based on achieving amore equitable allocation of resources e.g. providing basic state health care free at thepoint of use.Taxation and labour productivitySome economists argue that taxes can have a significant effect on the intensity with whichpeople work and their overall efficiency and productivity. But there is little substantiveempirical evidence to support this view. Many factors contribute to improving productivity tax

changes can play a role - but isolating the impact of tax cuts on productivity is extremelydifficult.

Taxation and business investment decisionsLower rates of corporation tax and other business taxes can stimulate an increase in businessfixed capital investment spending. If planned investment increases, the nations capital stockcan rise and the capital stock per worker employed can rise.The government might also use tax allowances to stimulate increases in research anddevelopment and encourage more business start-ups. A favourable tax regime could also beattractive to inflows of foreign direct investment a stimulus to the economy that mightbenefit both aggregate demand and supply. The Irish economy is often touted as an exampleof how substantial cuts in the rate of corporation tax can act as a magnet for large amounts of inward investment. The very low rates of company tax have been influential although it is notthe only factor that has underpinned the sensational rates of economic growth enjoyed by theIrish economy over the last fifteen years.


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Capital investment should not be seen solely in terms of the purchase of new machines.Changes to the tax system and specific areas of government spending might also be used tostimulate investment in technology, innovation, the skills of the labour force and socialinfrastructure. A good example of this might be a substantial increase in real spending on thetransport infrastructure. Improvements in our transport system would add directly toaggregate demand, but would also provide a boost to productivity and competitiveness.Similarly increases in capital spending in education would have feedback effects in the longterm on the supply-side of the economy.Fiscal Policy and Aggregate DemandTraditionally fiscal policy has been seen as an instrument of demand management . Thismeans that changes in spending and taxation can be used counter-cyclically to helpsmooth out some of the volatility of real national output particularly when the economy hasexperienced an external shock .Discretionary changes in fiscal policy and automatic stabilisersDiscretionary fiscal changes are deliberate changes in direct and indirect taxation andgovt spending for example a decision by the government to increase total capital spendingon the road building budget or increase the allocation of resources going direct into the NHS.Automatic fiscal changes are changes in tax revenues and government spending arising

automatically as the economy moves through different stages of the business cycle. Thesechanges are also known as the automatic stabilisers of fiscal policyTax revenues: When the economy is expanding rapidly the amount of tax revenue increaseswhich takes money out of the circular flow of income and spendingWelfare spending: A growing economy means that the government does not have to spendas much on means-tested welfare benefits such as income support and unemployment benefitsBudget balance and the circular flow: A fast-growing economy tends to lead to a netoutflow of money from the circular flow. Conversely during a slowdown or a recession, thegovernment normally ends up running a larger budget deficit.Estimates from economists at the OECD have found that the effects of the automatic stabilisersof fiscal policy can reduce the volatility of the economic cycle by up to 20%. In other words, if the government is prepared to allow the automatic stabilisers to work through fully, the fiscal

policy can help to curb the excessive growth of demand during a boom, but also provide animportant support for income and demand during an economic downturn.


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Measuring the fiscal stanceThe fiscal stance is a term that is used to describe whether fiscal policy is being used to

actively expand demand and output in the economy (a reflationary or expansionary fiscalstance) or conversely to take demand out of the circular flow (a deflationary fiscal stance).A neutral fiscal stance might be shown if the government runs with a balanced budget wheregovernment spending is equal to tax revenues. Adjusting for where the economy is in theeconomic cycle, a neutral fiscal stance means that policy has no impact on the level of economic activityA reflationary fiscal stance happens when the government is running a large deficit budget(i.e. G>T). Loosening the fiscal stance means the government borrows money to inject fundsinto the economy so as to increase the level of aggregate demand and economic activity.A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G


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when some components of AD (notably export demand and investment) have been weak.The Keynesian school argues that fiscal policy can have powerful effects on aggregatedemand, output and employment when the economy is operating well below full capacitynational output, and where there is a need to provide a demand-stimulus to the economy.Keynesians believe that there is a clear and justified role for the government to make activeuse of fiscal policy measures to manage the level of aggregate demand.

Monetarist economists on the other hand believe that government spending and taxchanges can only have a temporary effect on aggregate demand, output and jobs and that

monetary policy is a more effective instrument for controlling demand and inflationarypressure. They are much more sceptical about the wisdom of relying on fiscal policy as ameans of demand management. We will consider below some of the criticisms of using fiscalpolicy as a tool of stabilising demand and output in the economy.The multiplier effects of an expansionary fiscal policy depend on how much spareproductive capacity the economy has; how much of any increase in disposable income is spentrather than saved or spent on imports. And also the effects of fiscal policy on variables such asinterest rates


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Problems with Fiscal Policy as an Instrument of Demand ManagementIn theory a positive or negative output gap can be relatively easily overcome by the fine-tuning

of fiscal policy. However, in reality the situation is complex and many economists argue forignoring fiscal policy as a tool for managing aggregate demand focusing instead on the rolethat monetary policy can play in stabilising demand and output.Recognition lags and policy time lagsInevitably, it takes time to for government policy-makers to recognise that AD is growingeither too quickly or too slowly and a need for some active discretionary changes in spendingor taxationIt then takes time to implement an appropriate policy response government spending plansare subject to a three year spending review and cannot be changed immediately. Likewise thetax system is highly complex for example income tax can only normally be changed once ayear at the time of the Budget. Indirect taxes can be changed more quickly but they have lessof an effect on the level of aggregate demand

It then takes time for the change in fiscal policy to work, as the multiplier process on nationalincome, output and employment is not instantaneous.The importance of the national income multiplier imperfect informationSuppose a government wanted to eliminate a deflationary gap of 1000m. The increaseneeded in government expenditure will depend on the size of the multiplier. The problem lies inknowing the exact size of the multiplier. If the multiplier is 2, then government expenditurewould have to rise by 500m. However, if the multiplier was 4, a rise of only 250m would beneeded. Without knowing the precise value of the national income multiplier it is difficult tofine-tune the economy accurately.Fiscal Crowding-OutThe crowding-out hypothesis became popular in the 1970s and 1980s when free marketeconomists argued against the rising share of national income being taken by the publicsector. The essence of the crowding out view is that a rapid growth of government spendingleads to a transfer of scarce productive resources from the private sector to the publicsector. For example, if the government seeks to reflate AD by reducing taxation, or by


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increasing government spending, then this may lead to a budget deficit . To finance the deficitthe government will have to sell debt to the private sector. Attracting individuals andinstitutions to purchase the debt may require higher interest rates. A rise in interest rates maycrowd out private investment and consumption, offsetting the fiscal stimulus.This type of crowding out is unlikely to make fiscal policy wholly ineffective but large budgetdeficits do require financing and in the long run, this requires a higher burden of taxation.Higher taxes affect both businesses and households neo-liberal economists believe thathigher taxation acts as a drag on business investment, labour market incentives andproductivity growth all of which can have a negative effect on economic growth potential inthe long run.

The Keynesian response to the crowding-out hypothesis is that the probability of 100%crowding-out is extremely remote, especially if the economy is operating well below itsproductive capacity and if there is a plentiful supply of savings available that the governmentcan tap into when it needs to borrow money. There is no automatic relationship between the

level of government borrowing and the level of short term and long term interest rates. We cansee from the previous chart that there has been a downward trend in long term interest ratesover the last tent to twelve years. Indeed in 2003 the yield (rate of interest) on ten yeargovernment bonds dipped below 4 per cent one of the lowest long term interest rates inrecent history.Reaction to Tax Cuts Rational ExpectationsAccording to a school of economic thought that believes in rational expectations , when thegovernment sells debt to fund a tax cut or an increase in expenditure, then a rational individualwill realise that at some future date he will face higher tax liabilities to pay for the interestrepayments. Thus, he should increase his savings as there has been no increase in hispermanent income. The implications are clear. Any change in fiscal policy will have no impacton the economy if all individuals are rational. Fiscal policy in these circumstances may becomeimpotent.Partly because of the limitations of fiscal policy as a tool of demand management, manygovernments have switched the focus of fiscal policy towards using it to improve aggregate


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supply as a means of creating the conditions for sustainable economic growth. This is certainlythe case with the current government.Government borrowingThe level of government borrowing is an important part of fiscal policy and management of aggregate demand in any economy. When the government is running a budget deficit , itmeans that in a given year, total government expenditure exceeds total tax revenue. As aresult, the government has to borrow through the issue of debt such as Treasury Bills andlong-term government Bonds. The issue of debt is done by the central bank and involvesselling debt to the bond and bill markets.Recent trends in UK government borrowing

Government finances have moved from surplus in the late 1990s to a deficit of over 2.5 % of GDP in 2003-04. The emergence of a rising budget deficit has been due to a weaker economyand the effects of substantial increases in government spending on priority areas such as

health, education, transport and defence. Both current and capital spending are rising sharplyin real terms. Critics of Gordon Brown argue that he risks losing control of the budget deficit if tax revenues continue to come in below forecast whilst public sector spending remains high.Gordon Browns reputation of fiscal prudence has come under pressure both before and afterthe most recent election.Does a budget deficit matter?There is a consensus that a persistently large budget deficit can be a problem for thegovernment and the economy. Three of the reasons for this are as follows:Financing a deficit: A budget deficit has to be financed and day-today, the issue of newgovernment debt to domestic or overseas investors can do this. In a world where financialcapital flows freely between countries, it can be relatively easy to finance a deficit. But it maybe that if the budget deficit rises to a high level, in the medium term the government mayhave to offer higher interest rates to attract sufficient buyers of government debt. This in turnwill have a negative effect on economic growthA government debt mountain? In the long run, government borrowing adds to the


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accumulated National Debt . This means that the Government has to spend more each year indebt-interest payments to holders of government bonds and other securities. There isan opportunity cost involved here because this money might be used in more productiveways, for example an increase in spending on health services or extra investment in education.It also represents a transfer of income from people and businesses that pay taxes to those whohold government debt and cause a redistribution of income and wealth in the economyCrowding-out - the need for higher interest rates and higher taxes. Eventually thebudget deficit has to be reduced. This can be achieved by either by cutting back on publicsector spending or by raising the burden of taxation. If a larger budget deficit leads to higherinterest rates and taxation in the medium term and thereby has a negative effect on growth inconsumption and investment spending, then a process of fiscal crowding-out is said to beoccurring.Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of government spending. They believe that a rising share of GDP taken by the state sector has anegative effect on the growth of the private sector of the economy. They are sceptical aboutthe benefits of higher spending believing that the scale of waste in the public sector is high money that would be better off being used by the private sector.

Potential benefits of a budget deficitWhat are the main economic and social justifications for a higher level of government spendingand borrowing? Two main arguments stand outGovernment borrowing can benefit economic growth: A budget deficit can have positivemacroeconomic effects in the long run if it is used to finance extra capital spending that leadsto an increase in the stock of national assets . For example, spending on the transportinfrastructure improves the supply-side capacity of the economy . And increasedinvestment in health and education can bring positive effects on productivity andemployment .The budget deficit as a tool of demand management: Keynesian economists wouldsupport the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to


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demand when other sectors of the economy are suffering from weak or falling spending. Thefiscal stimulus given to the British economy during 2002-2004 has been importantin stabilizing demand and output at a time of global economic uncertainty. PerhapsKeynesian fiscal demand management has once more come back into fashion! The argument isthat the government can and should use fiscal policy to keep real national output closer topotential GDP so that we avoid a large negative output gap .The current situationGovernment borrowing in the UK has shot up to 3.4 percent of GDP in the last fiscal year, inexcess of the 3.0 percent limit set by Europe's Stability and Growth Pact. But as the UK is notparticipating in the single currency, the UK is not bound by the terms of the fiscal stability pactand this gives it more flexibility in terms of how much the UK government can borrowThe government has allowed the automatic stabilisers to work during the current cycle. Inother words, it has allowed an increase in government borrowing brought about by a slowdownin domestic demand and output.Gordon Brown has introduced his own fiscal rules including the golden rule thatgovernment spending on currently provided goods and services should be financed by taxationover the course of the economic cycle. Government capital spending (public sector investment)can be financed by borrowing because it results in the accumulation of capital which has long

term economic benefits for the countryAlthough government borrowing is currently high, there is little upward pressure on long-terminterest rates (indeed they are low). Financing the budget deficit is not a major problem for theUK as it seems able to attract inflows of financial capital from overseas and foreign investorsare happy to purchase new issues of government debt. This reduces the risk of the crowdingout effect taking placeTotal government debt as a percentage of GDP remains low by historical standards (less than40% of GDP). And with interest rates remaining low, the government is not facing up to a hugecost of servicing this debtIt is difficult to forecast government borrowing with great accuracy. Firstly this is becausegovernment tax revenue and spending is sensitive to changes in the economic cycle. Secondly,we are dealing with huge numbers! Total government spending in 2003-04 is forecast to be

459 billion and total tax receipts 422 billion (giving a forecast budget deficit of 37 billion).It only takes government spending and tax revenues to be 1% or 2% different from currentforecasts for the budget deficit to change significantlyInter-relationships between Fiscal & Monetary PolicyFiscal policy should not be seen is isolation from monetary policy.For most of the last thirty years, the operation of fiscal and monetary policy was in the handsof just one person the Chancellor of the Exchequer. However the degree of coordination thetwo policies often left a lot to be desired. Even though the BoE has independence that allows itto set interest rates, the decisions of the MPC are taken in full knowledge of the Governmentsfiscal policy stance. Indeed the Treasury has a non-voting representative at MPC meetings. Thegovernment lets the MPC know of fiscal policy decisions that will appear in the budget.Impact of fiscal policy on the composition of output

Monetary policy is often seen as something of a blunt policy instrument affecting allsectors of the economy although in different ways and with a variable impact. Fiscal policychanges can to a degree be targeted to affect certain groups (e.g. increases in means-testedbenefits for low income households, reductions in the rate of corporation tax for small-mediumsized enterprises and more generous investment allowances for businesses in certain regions)Consider the effects of using either monetary or fiscal policy to achieve a given increase innational income because actual GDP lies below potential GDP (i.e. there is a negative outputgap)Monetary policy expansion : Lower interest rates will (ceteris paribus) lead to an increase inboth consumer and business capital spending both of which increases equilibrium nationalincome. Since investment spending results in a larger capital stock, then incomes in the futurewill also be higher through the impact on LRAS.Fiscal policy expansion : An expansionary fiscal policy (i.e. an increase in governmentspending or lower taxes) adds directly to AD but if this is financed by higher borrowing, thismay result in higher interest rates and lower investment. The net result (by adjusting the


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increase in G) is the same increase in current income. However, since investment spending islower, the capital stock is lower than it would have been, so that future incomes are lower.Effectiveness of Monetary and Fiscal PoliciesWhen the economy is in a recession, monetary policy may be ineffective in increasing spendingand income. In this case, fiscal policy might be more effective in stimulating demand. Othereconomists disagree they argue that changes in monetary policy can impact quite quicklyand strongly on consumer and business behaviour.However, there may be factors which make fiscal policy ineffective aside from the usualcrowding out phenomena. Future-oriented consumption theories based round the concept of rational expectations hold that individuals undo government fiscal policy through changes intheir own behaviour for example, if government spending and borrowing rises, people mayexpect an increase in the tax burden in future years, and therefore increase their currentsavings in anticipation of thisDifferences in the Lags of Monetary and Fiscal PoliciesMonetary and fiscal policies differ in the speed with which each takes effect the time lags arevariableMonetary policy in the UK is flexible since interest rates can be changed by the Bank of England each month and emergency rate changes can be made in between meetings of the

MPC, whereas changes in taxation take longer to organize and implement.Because capital investment requires planning for the future, it may take some time beforedecreases in interest rates are translated into increased investment spending. Typically it takessix months twelve months or more before the effects of changes in UK monetary policy arefelt. The impact of increased government spending is felt as soon as the spending takes placeand cuts in direct and indirect taxation feed through into the economy pretty quickly. However,considerable time may pass between the decision to adopt a government spending programmeand its implementation. In recent years, the government has undershot on its plannedspending, partly because of problems in attracting sufficient extra staff into key public servicessuch as transport, education and health.

Author: Geoff Riley, Eton College, September 2006

nflationSunday, 19 September 2010 23:50 H.Lalnunmawia

INFLATIONInflation may be defined as a persistent and appreciable rise in the general price level.

Inflation is statistically measured in terms of percentage increase in the price index over aperiod of time usually a year or a month.Inflationary gap: The inflationary gap is the amount by which aggregate demand exceedsaggregate supply at the full employment level of income. The inflationary gap is explaineddiagrammatically in the following figure.
http://trcollege.net/component/content/123-inflation-?format=pdfhttp://trcollege.net/component/content/123-inflation-?tmpl=component&print=1&page=


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In the figure Y F is the full employment level of income, the 45 line represents aggregatesupply (AS), and the C + I + G line represent the aggregate demand (AD). The economysaggregate demand curve (AD) intersects the aggregate supply curve (AS) at point E at theincome level OY 1 which is greater than the full employment income level OY F. The amount bywhich aggregate demand Y FA exceeds the aggregate supply Y FB at the full employmentincome level is the inflationary gap. This is AB in the figure. Thus, the inflationary gap leads toinflationary pressures in the economy which are the result of excess aggregate demand.Types of InflationThere are several types of inflation in the economy which are classified on different basis.Some of the important types of inflation are discussed below.Creeping, Walking, Running and Galloping Inflation:(a) Creeping Inflation: When the rise in prices is very slow (less than 3% per annum) likethat of a snail or creeper, it is called creeping inflation. Such an increase in prices is regardedsafe and essential for economic growth.(b) Walking or Trotting Inflation: When prices rise moderately and the annual inflation rate is

a single digit (3% - 10%), it is called walking or trotting inflation. Inflation at this rate is awarning signal for the government to control it before it turns into running inflation.(c) Running Inflation: When prices rise rapidly like the running of a horse at a rate of speedof 10% - 20% per annum, it is called running inflation. Its control requires strong monetaryand fiscal measures, otherwise it leads to hyperinflation.(d) Galloping or Hyperinflation: When prices rises between 20% to 100% per annum or evenmore, it is called galloping or hyperinflation. Such a situation brings a total collapse of themonetary system because of the continuous fall in the purchasing power of money.Demand-Pull and Cost-Push Inflation:. Demand-pull inflation takes place when aggregatedemand is rising while the available supply of goods is less. The monetarists emphasize the

role of money as the principal cause of demand-pull inflation while the Keynesians emphasizethe increase in aggregate demand as the causes of inflation. On the other hand, Cost-pushinflation is caused by wage increases enforced by trade unions and profit increases byemployers.Comprehensive and Sporadic Inflation: When the prices of all commodities in the economyrise it is called comprehensive inflation. On the other hand, sporadic inflation is a sectoralinflation in which the prices of a few commodities rise because of certain physical bottleneckswhich may impede any attempt to increase their production.Open and Suppressed Inflation: Inflation is said to be open when the government takes nosteps to control the rise in the price level. Thus open inflation is the result of the uninterruptedoperation of the market mechanism. On the other hand, inflation is said to be suppressedwhen the government actively intervenes to check the rise in the price level.


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Mark-up Inflation: This type of inflation resulted from the peculiar method of pricing adoptedby the big business organizations. According to this method, the big business organizationscalculate their production costs first and then add to these costs a certain mark-up to yield thetargeted rate of profit.Besides the above types of inflation, there are several other types of inflation which areclassified on the basis of time or the causes of inflation. On the basis of time there arepeacetime, wartime and postwar inflation. On the basis of factors causing inflation there arecredit inflation, deficit-induced inflation, scarcity-induced inflation etc.Causes of InflationBroadly speaking inflation arises when the aggregate demand exceeds the aggregate supplyof goods and services. We analyse the factors which lead to increase in demand and theshortage of supply.Factors Causing Increase in Demand: Both Keynesians and monetarists believe that inflationis caused by increase in the aggregate demand. Following are the factors which cause anincrease in the size of demand:

1. Increase in Money Supply: Inflation is caused by an increase in the supply of moneywhich leads to increase in aggregate demand. The higher the growth rate of nominal

money supply, the higher is the rate of inflation.

2. Increase in Disposable Income: When the disposable income of the people increases,

it raises their demand for goods and services. Disposable income may increase with the

rise in national income or reduction in taxes or reduction in the saving of the people.

3. Increase in Public Expenditure: In modern world government activities have been

expanding which resulted in increase government expenditure. This raised the

aggregate demand for goods and services, thereby causing inflation.

4. Increase in Consumer Spending: The demand for goods and services also increases

when consumer spending increases due to conspicuous consumption or demonstration

effect.

5. Cheap Monetary Policy: Cheap monetary policy or the policy of credit expansion also

leads to increase in the money supply which raises the demand for goods and services

in the economy thereby leading to inflation. This is also known as credit-induced

inflation.

6. Deficit Financing: In order to meet its mounting expenses, the government resorts to

deficit financing by borrowing from the public and even by printing more notes. This

raises aggregate demand in relation to aggregate supply, thereby leading to inflationary

rise in prices.7. Increase in Exports: When the demand for domestically produced goods increases in

foreign countries, this raises the earnings of industries producing export commodities.

These, in turn, create more demand for goods and services within the economy.Apart from the above factors, expansion of the private sector, existence of black money andthe repayment of public debt by the government also increases the aggregate demand for goods and services in the economy.Factors Causing Shortage of Supply: Following are the factor which result in a reduction inthe supply of goods and services:

1. Shortage of factors of production: When there is shortage of factors of production like

labour, capital, raw materials, etc. there is bound to be reduction in the production of goods and services.


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2. Industrial Disputes: In countries where trade unions are powerful, they resort to

strikes and lock-outs which resulted in a fall in industrial production thereby reducing the

supply of goods.

3. Natural Calamities: Natural calamities like droughts, floods, etc. adversely affects the

supplies of agricultural products. This creates shortage of food products and rawmaterials, thereby helping inflationary pressures.

4. Artificial Scarcities: Artificial scarcities are created by hoarders and speculators who

indulge in black marketing. Thus, they are instrumental in reducing supplies of goods

and raising their prices.

5. Increase in Exports: When the country produces more goods for exports than for

domestic consumption, this creates shortages of goods in the domestic market. This

leads to inflation in the economy.

6. Lop-sided production: If the stress is on the production of comforts, luxuries, or basic

products to the neglect of essential consumer goods in the country this creates

shortages of consumer goods. This again causes inflation.

7. Law of Diminishing Returns: If industries in the country are using old machine and

outmoded methods of production, the law of diminishing returns operates. This raises

cost per unit of production, thereby raising the prices of products.International Factors: In modern times, inflation is a worldwide phenomenon. When prices risein major industrial countries, their effects spread to almost all countries with which they havetrade relations. Often the rise in price of a basic raw material like petrol in the internationalmarket leads to rise in the price of all related commodities in a country.Measures To Control InflationInflation is caused by the failure of aggregate supply to equal the increase in aggregatedemand. Therefore, inflation can be controlled by increasing the supplies of goods andreducing money income. The various measures to control inflation are discussed below.Monetary MeasuresThe monetary measures to control inflation generally aims at reducing money incomes. Theseare:(a) Credit Control: The central bank could adopt a number of methods to control the quantityand quality of credit to reduce the supply of money. For this purpose, it raises the bank rates,sells securities in the open market, raises reserve ratio, and adopts a number of selectivecredit control measures, such as raising margin requirements and regulating consumer credit.(b) Demonetisation of Currency: Another monetary measure is to demonetise currency of

higher denominations. Such a measure is usually adopted when there is abundance of blackmoney in the country.(c) Issue of New Currency: The most extreme monetary measure is the issue of new currencyin place of the old currency. Under this system, one new note is exchanged for a number of the old currency. Such a measure is adopted when there is an excessive issue of notes andthere is hyperinflation in the economy.Fiscal MeasuresMonetary policy alone cannot control inflation. Therefore, it should be supplemented by fiscalmeasures. The principal fiscal measures are discussed below.(a) Reduction in Unnecessary Expenditure: The government should reduce unnecessaryexpenditure on non-development activities in order to curb inflation.


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(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, butthe rates of taxes should not be too high as to discourage saving, investment and production.(c) Increase in Savings: Another measure is to increase savings on the part of the people sothat their disposable income and purchasing power would be reduced. For this thegovernment should encourage savings by giving various incentives.(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 surplusbudgets. It means collecting more in revenues and spending less.(e) Public Debt: In addition, the government should stop repayment of public debt andpostpone it to some future date till inflationary pressures are controlled. Instead, thegovernment should borrow more to reduce money supply with the public. Other (Direct) MeasuresOther measures to control inflation generally aims at increasing aggregate supply andreducing aggregate demand directly. These are :-

(a) To Increase Production. The following measures should be adopted to increaseproduction:(i) The government should encourage the production of essential consumer goodslike food, clothing, kerosene oil, sugar, vegetable oils, etc.(ii) All possible help in the form of latest technology, raw materials, financial help,subsidies, etc. should be provided to different consumer goods sectors to increaseproduction.(b) Rational Wage Policy: Another important measure is to adopt a rational wage policy. Thebest course for this is to link increase in wages to increase in productivity. This will have adual effect. It will control wage and at the same time increase production of goods in theeconomy.(c) Price Control: Price control and rationing is another measure of direct control to checkinflation. Price control means fixing an upper limit for the prices of essential consumer goods.(d) Rationing: Rationing aims at distributing consumption of scarce goods so as to make themavailable to a large number of consumers. It is applied to essential consumer goods such aswheat, rice, sugar, kerosene oil, etc. It is meant to stabilize the prices of necessaries andassure distributive justice.Conclusion: From the various monetary, fiscal and other measures, discussed above, itbecomes clear that to control inflation, the government should adopt all measuressimultaneously.Effects of Inflation

Inflation affects different people differently. When price rises or the value of money falls, somegroups of the society gain, some lose and some stand in between. Let us discuss the effectsof inflation on distribution of income and wealth, production, and on the society as a whole.

1. Effects of Inflation on Business Community: Inflation is welcomed by entrepreneurs

and businessmen because they stand to profit by rising prices. They find that the value

of their inventories and stock of goods is rising in money terms. They also find that prices

are rising faster than the costs of production, so that their profit is greatly enhanced.

2. Fixed Income Groups: Inflation hits wage-earners and salaried people very hard.Although wage- earners, by the grace of trade unions, can chase galloping prices, they


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seldom win the race. Since wages do not rise at the same rate and at the same time as

the general price level, the cost of living index rises, and the real income of the wage

earner decreases.

3. Farmers: Farmers usually gain during inflation, because they can get better prices for

their harvest during inflation4. Investors: Those who invest in debentures and fixed-interest bearing securities,

bonds, etc, lose during inflation. However, investors in equities benefit because more

dividend is yielded on account of high profit made by joint-stock companies during

inflation.

5. Inflation will lead to deterioration of gross domestic savings and less capital formation

in the economy and less long term economic growth rate of the economy.

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Lecture Notes- Macroeconomics