CHAPTER 1
INTRODUCTION OF INFLATION
1.1 BACKGROUND OF THE STUDY
Inflation as a topic of study has received broad attention in
academic and policy literature over many years. Inflation is a
persistent and appreciable rise in the general price level or
average of prices. It is said that when the quantity of money used
as the medium of exchange in the economy is more than quantity of
goods and services, inflation is most probable. This can be caused
due to some direct causes such as increase of income or some
indirect cause such as political forces in an economy. Since Nepal
is currently under transition phase, several factors contribute for
the increasing price rate. Increase in income of consumers, credit
policy, natural causes, lack of raw materials, techniques of
productions, industrial disputes and political factors are some of
the causes of inflation in Nepal. The political instability has
caused several social problems such as strikes, social insecurity,
etc. As such the investors have been highly discouraged. Another
factor causing inflation is the credit policy. The demand for
credit has been in quite an amount and thus commercial banks have
only a smaller amount of money in their cash-fund so that large
amount of money is circulated in society. So the increase in use of
money in society creates inflation.
Inflation is supposed to have negative effect in an economy but
sometimes the inflation of smaller rates can provide some motion to
the economy. This sort of motion increases the employment and leads
economy towards development. But when the inflation rate is high
this will affect the economy negatively such as it creates
hindrances in capital formation and creation of black market. So
inflation is not necessarily bad.1.2 MEASUREMENT OF INFLATION
Measuring inflation in an economy requires objective means of
differentiating changes in nominal prices on a common set of goods
and services, and distinguishing them from those price shifts
resulting from changes in value such as volume, quality, or
performance. People consider the rate of inflation important
because it affects their planning. The price at which people borrow
and lend funds will also depend heavily on what they expect to
happen to prices.
Inflation is usually estimated by calculating the inflation rate
of a price index, usually the Consumer Price Index. The inflation
rate is the percentage rate of change of a price index over time.
There are various indices which measure the price level, such as;
consumer price index (CPI): wholesale price index (WPI); sensitive
price index (SPI); gross domestic product (GDP) deflator and so on.
In Nepal, there are three main price indices, namely: the CPI; the
WPI; and the Salary and Wage Rate Index (SWRI). 4 The main focus
for measuring the cost of living is placed on CPI.
1.2.1 Consumer Price Index
The Consumer Price Index measures prices of a selection of goods
and services purchased by a "typical consumer. CPI is the weighted
average of prices of a basket of consumer goods and services, such
as transportation, food and medical care. The CPI is calculated by
taking price changes for each item in the predetermined basket of
goods and averaging them. Changes in CPI are used to assess price
changes associated with the cost of living. The Consumer Price
Index, for example, uses data collected by surveying households to
determine what proportion of the typical consumer's overall
spending is spent on specific goods and services, and weights the
average prices of those items accordingly.1.2.2 Wholesale Price
Index
It is also known as Producer Price Index which reflects the
wholesale prices of various goods and services, and is similar to
the CPI construction. It measures the average change over time in
selling price by domestic producers of goods and services. It
measures the pressure being put on producers by the costs of their
raw materials. This could be "passed on" to consumers, or it could
be absorbed by profits, or offset by increasing productivity. This
differs from the CPI in that price subsidization, profits, and
taxes may cause the amount received by the producer to differ from
what the consumer paid. There is also typically a delay between an
increase in the PPI and any eventual increase in the CPI.1.2.3 GDP
Deflator
This is broader measure of inflation. GDP deflator is
constructed by taking the ratio of Nominal GDP to Real GDP. This
measure is used to calculate the price change or inflation of all
goods and services produced in an economy over time. The US
Commerce Department publishes a deflator series for US GDP, defined
as its nominal GDP measure divided by its real GDP measure. Unlike
some price indexes, the GDP deflator is not based on a fixed basket
of goods and services. The basket is allowed to change with
people's consumption and investment patterns. The advantage of this
approach is that the GDP deflator reflects up to date expenditure
patterns
Inflation measures are often modified over time, either for the
relative weight of goods in the basket, or in the way in which
goods and services from the present are compared with goods and
services from the past. Over time adjustments are made to the type
of goods and services selected in order to reflect changes in the
sorts of goods and services purchased by 'typical consumers'. New
products may be introduced, older products disappear, the quality
of existing products may change, and consumer preferences can
shift. Both the sorts of goods and services which are included in
the "basket" and the weighted price used in inflation measures will
be changed over time in order to keep pace with the changing
marketplace.1.3 TRENDS OF INFLATION IN NEPAL
Prices in Nepal are also greatly influenced by inflation in
India since the Nepali rupee is pegged to the Indian currency. In
Nepal monetary stance cannot sustain prices that differ from Indian
prices for a long time as price differentials cause smuggling;
changes in monetary posture eventually shows up in the changes in
international reserves. The rate of rise in general price level has
continued to moderate closer to the target in spite of supply and
demand side pressures. Inflation has been high because of imported
Indian inflation, high international commodity prices.
Since the average price inflation trends in the last five year
has been unstable, it seems challenging to keep the annual
inflation rate in stable trends due to supply constraints, frequent
price rise of petroleum products, continuous rise in wage rate and
pressure from rising food prices in recent period. In addition, the
prolonged political instability and lack of investment friendly
climate have caused the productivity to decline. Hence, the role of
monetary policy seems tough to control the inflation rate within
desired level.
The following table shows the trends of inflation rate from 2008
to 2012:
Table 1: Trends of inflation rate
YearInflation, average consumer pricesPercent Change
20087.719.64 %
200913.22671.77 %
201010.512-20.52 %
20119.6-8.66%
20127.5-21.875%
In above table, it has been shown that during 2009 and 2010,
there was a double-digit inflation because of world economic
recession on 2008 which affects economy of Nepal too. The inflation
rate of 2011 and 2012 shows the inflation rate is in decreasing
trends. The monetary policy for FY 2012/13 has set the target of
attaining economic growth of 5.5 percent, limiting inflation at 7.5
percent and maintaining foreign exchange reserves sufficient to
cover imports of goods and services of at least eight months.
Figure 1: Inflation Trends
CHAPTER 2
TRENDS OF INFLATION IN NEPAL
2.1 INFLATION IN NEPALIn Nepal, money supply and interest rate,
which are the basic tools of monetary policy, do not seem to have
been able to slow down inflation. Since a few years, Nepal has
experienced a rapidly rising inflationary trend. These gearing-up
dynamics of inflationary trend have rudely shocked different
cross-sections of the intelligentsia. In 2013, Nepalese have to
endure a high inflation of 10.2 per cent. Taking into consideration
the persistently high inflation in Nepal, apart from monetary
policy and fiscal policy, the government should pay attention to
some of the vital factors in taming inflation. First, oil price
fluctuations wield a uniquely critical pressure on inflation
throughoutthe world.For meeting the requirement either a dynamo of
power should be entrusted to Nepal Oil Corporation, the sole agent
of fuel supply or privatize the whole system of importing petroleum
products to ensure smooth supply in the market. Second, imported
inflation, if strong enough, is heavily anti-cyclical since it
stimulates a decrease in output growth.Therefore, it has become
inevitable in altering the western practices, style and consumption
habits of the majority of the population who belong to the younger
generation. Attitudinal changes should be induced aggressively in
the habit of purchasing exotic consumer goods.Third, as the country
is fully reliant on import of petroleum products the government
should pursue on a priority basis means of enhancing renewable
energy, wind energy and should briskly indulge in centering its
attention on developing micro and macro hydropower as we all know
that our countrys import of petrol only exceeds total export value
of the country.
2.2 FOOD AND NON-FOOD INFLATIONInflation in Nepal is largely
affected by rising food price in the country, which is a global
phenomenon also in the present context. The main driving forces
behind Nepals inflation - food and nonfood are Indias inflation and
movements of international oil prices. However, inflation in food
component has come down to single digit after a long time in
October 2011. Non food inflation would go higher in the future if
the present exchange rate trend (especially USD exchange rate
appreciation) still goes to upward direction. Overall consumer
price inflation in Nepal has been influenced by rising prices of
food and petroleum products and rising inflation India. Although
Nepal maintains an open border with India and pegs its currency to
the Indian rupee, Nepals inflation rate does not go in lockstep
with that of India. Rising inflation in Nepal has been mainly
driven by food price inflation.
Eliminating food prices from core inflation may provide an
incorrect picture of underlying inflation trends, especially in low
income countries, for three primary reasons: First, a core measure
of inflation must have the same medium-term mean as the headline
measure. However, food inflation is in many countries higher than
nonfood inflation, making it likely that a core inflation measure
excluding food prices will show lower inflation even in the long
run than headline inflation. This is of particular concern among
poorer countries, where in some cases food inflation is
significantly higher than nonfood inflation. Second, excluding food
prices from core measures (or assigning them a lower weight) due to
their perceived transience is also in many cases unjustified. In
the sample analyzed here, food inflation in many cases is quite
persistent, in many countries more so than nonfood prices. This
relationship is also particularly pronounced in poorer countries
where food is a large share of the consumption basket. In such
countries, the slow dissipation of food shocks could lead to higher
expectations not only for food inflation but for overall inflation
as well. Given the higher volatility of food price shocks, a core
inflation measure that excludes food prices will miss these
shocks.
2.2.1 Food Inflation and Nonfood Inflation
There are two important points where differences in distribution
of food and nonfood shocks can be significant. First, as Stephen
Cecchetti (2007) points out, excluding food from a core measure of
inflation is only justified when the long-run mean of food
inflation is equal to the long run mean of nonfood inflation: if
this is not the case, then core inflation will systematically
underestimate headline inflation. That is, if policymakers are
interested in the overall price level, ignoring food price dynamics
only makes sense if these do not impact the long-run price level;
if they do, then they have to be taken into account. Second, it is
also important to look at the volatility of food price shocks. If
food price shocks are more volatile than nonfood price shocks, they
add to the noise to signal ratio that policymakers contend with in
assessing inflation. The larger and more frequent these shocks to
food inflation are, the likelier it is that they not only lead to
erroneous diagnoses of the level of underlying inflation, but also
the likelier it is that those shocks can affect nonfood prices as
well. This propagation mechanism may not exist everywhere, and this
possibility is discussed below. If food shocks tend to be small,
then even the long-run effect is likely to be minimal. However, if
food shocks are larger and more volatile than nonfood shocks, then
even if the propagation mechanism is weak, food shocks may have
serious knock-on effects on nonfood prices.
Core inflation indices can be derived in many ways, the end
result in most advanced economies is to minimize or eliminate
volatile categories, which often translates into excluding food and
energy. While the greater role of food prices in emerging economies
is acknowledged by all central bankers, core inflation measures
excluding food price changes are also widely cited and can inform
policy decisions. It is not clear, however, that the
characteristics of both food and nonfood prices that justify the
minimization of food price inflation in advanced-economy core
measures apply in developing economies.
The Food and Beverage group makes up of 46.82% of the CPI and
the remaining 53.18% is composed of the Non Food and Service group.
The index of food and beverage group increased by 8.7% compared to
an increase by 7.1% in the corresponding period of the previous
year; whereas non-food and services group increased by 11.8%
compared to an increase by 7.8% in the corresponding period of the
previous year.
Changes in the Food and Beverage Group:
Under the Food and Beverage group, the price index of ghee and
oil sub-group, increased the most by 18.7% during the review
period, compared to an increase of 12.5% in the corresponding
period of the previous year.
Cereals and their products increased by 5% as compared to 2.1%
in the previous review period. The price index of tobacco products
and sugar, which had increased by 11.4% and 7.8% in the
corresponding period of the previous year, went up by 17.9% and
15.4% respectively.
Similarly, the price indices of meat and fish and restaurant and
hotel, which had risen by 5.7% and 9.2% respectively, in the
corresponding period of the previous year, increased by 13.3% and
12.9% respectively during the review period. The price indices of
legume varieties, which had increased by 0.3% in the corresponding
period of the previous year, rose by 11.2%.
Food price inflation has a direct correlation with the price of
oil and fertilizers used in agricultural production, transportation
cost of agricultural products and use of energy in irrigation.
Changes in the Non-Food and Services group:
Within the Non-Food and Services group, the price index of
furnishing and household equipment increased by 15.6% during the
review period, compared to an increase fo 13.7% in the
corresponding period of the previous year; thereby, becoming one of
the groups whose price increased the most,
The price indices of transport increased by 15.1%, which had
increased by 12.5%in the corresponding period of the previous year.
The transport price is heavily influenced by the price of petrol
and diesel.
Similarly, the price indices of housing and utilities, the
sub-group that represents the highest proportion of the Non-Food
and Service group, i.e. 10.87%, increased by 12.6% compared to an
increase by 3.5% in the previous year.
The education sub-group increased by 12.5%; it had increased by
8.9% in the corresponding period of the previous year. The only
decline was seen in the price index of communication, which
decreased by 2.7%. The sub-group had previously decreased by
8.8%.
CPI Components %2011/2012%2012/2013
Food and Beverage 7.18.7
Ghee and Oil12.518.7
Tobacco Products11.417.9
Sugar and Sweets7.815.4
Meat and Fish5.713.3
Restaurant and Hotel9.212.9
Hard Drinks-2.212.1
Soft Drinks4.211.5
Legume Varieties0.311.2
Milk Products and Egg1310.8
Fruits207
Cereals Grains and their products2.15
Vegetables18.84
Spices-8.30.6
Non-Food and Services7.811.8
Furnishing & Household
Equipment13.715.6
Transport12.515.1
Clothing & Footwear15.213.9
Housing & Utilities3.512.6
Education8.912.5
Miscellaneous Goods &
Services9.710.8
Recreation and Culture7.110
Health3.78.1
Communication-8.8-2.7
Fig: CPI based on Groups/Sub-groups, Mid December 2012 (Base
Year 2005/06 =100)
Source: NRB2.3 REGIONAL INFLATION SCENARIO (TERAI, HILLS AND
KATHMANDU VALLEY)During the review period, the Hilly region saw the
price index rise by 11.2% while the Terai region at 11.1%. The
index for the Kathmandu valley rose by 8.8%. The increments were
9.6%, 7.3% and 6% respectively in the corresponding period of the
previous year.
In the Kathmandu valley, the Food and Beverage group increased
by 6.2 % compared to an increase of 7.6% previously, whereas, the
Non-Food and Services group increased by 11%, compared to an
increase of 4.7% in the previous period.
In the Hilly region, the Food and Beverage and Non-Food and
Services groups increased by 9.6% and 12.6% respectively in the
review period. They had increased by 11.1% and 8.2% in the previous
review period. Similarly, in the Terai region, the Food and
Beverage group increased by 10% compared to an increase of 4.4% in
the corresponding period of the previous year. The Non- Food and
Services group increased by 12% compared to an increase of 9.7%
previous review period.
GROUPS AND SUB-GROUPS%2011/2012%2012/2013
CPI: Kathmandu Valley
Overall Index68.8
Food and Beverage7.66.2
Non-Food and Services4.711
CPI: Hill
Overall Index9.611.2
Food and Beverage11.19.6
Non-Food and Services8.212.6
CPI: Terai
Overall Index7.311.1
Food and Beverage4.410
Non-Food and Services9.712
Fig: CPI changes based on regionSource: NRB
CHAPTER 3
CAUSES OF INFLATION IN NEPAL
Nepal is currently under transition phase and thus several
factors contribute for the increasing in price rate. Increase in
income of consumers, credit policy, natural causes, lack of raw
materials, techniques of productions, industrial disputes and
political factors are some of the causes of inflation in Nepal.
Inflation is caused by an excessive increase in effective demand
and production cost in the economy. Normally, it is caused due to
the disequilibrium caused in aggregate demand and aggregate
supply.
3.1 DEMAND-PULL INFLATION
The demand pull inflation refers to the rise in the general
price level when aggregate demand increases much more rapidly than
the aggregate supply. It is mainly caused by demand raising factors
such as increase in money supply, public expenditure, exports and
population and decrease in tax rate. It is mainly characterized by
rise in output, income and employment with the rise in price level
up to full employment and increase in only price level after full
employment.
In the figure above, AD curve intersect AS curve at e1, giving
Y1 and P1 the original output and price respectively. A decrease in
aggregate demand shift aggregate demand curve to AD3, giving Y3
income level and P3 general price level. Similarly an increase in
aggregate demand shifts the aggregate demand curve to AD2, giving
Y2 income level and P2 general price level. This happen till AD2
demand curve and corresponding P2 but increase in aggregate demand
leads to increase in price level only. Keynes describes such a
raise in price level after attainment of full employment output as
pure inflation.
The main causes of increase in aggregate demand are as follows -
some are related with Keynesians and others with Monetarists:
Increase in money supply and bank credit:
Due to the excess liquidity in the Nepalese market the money
supply has been increased and the interest rate has been decreased.
As the result, consumption and investment expenditure increase.
This leads to an excessive increase in demand which increases the
price level.
Reduction in taxation:
The low tax rate increases the purchasing power of people.
Hence, if the government reduces the tax rate so as to give relief
to the people, the disposable income increases. Consequently the
consumption expenditure increases and inflation occurs. However in
case of Nepal the tax rate is consistent for a long period of time
i.e. VAT is 13%.
Deficit financing of the government:
In Nepal, deficit financing is taken as excess of government
expenditure over current revenue and public borrowing. This deficit
is financed by borrowing from the central bank and commercial
banks. Deficit financing, therefore, leads to increasing money
supply and hence is responsible for the price rise.
Increase in private expenditure:
In Nepal, the income of the people has increased due to the
increase in economic activities and investment. This has rapidly
increased the consumption and investment expenditure. As a result
aggregate demand increases and inflation occurs. Shortage of goods
and services:
The price level increases when the supply of goods and services
are lower in relation to demand. The production and supply
decreases in Nepal due to scarcity of factors of production,
hoarding by businessman and scarcity of raw materials especially in
petroleum products.
Increase in population:
Increase in population is another factor for inflationary rise
in prices, particularly in Nepalese context. Increase in population
means increase demand for most of the consumer goods. It increases
the aggregate demand for goods and services and puts pressure on
existing supply of goods and services.
Black Money:
The existence of black money in Nepal due to corruption, tax
evasion, gambling, etc. increases the aggregate demand. People
spend much unearned money extravagantly, thereby creating
unnecessary demand for commodities. This tends to raise the price
level further.
3.2 COST-PUSH INFLATIONThe cost push inflation is caused by the
monopoly power exercised by some monopoly groups of the society,
like labor unions and firms in monopolistic and oligopolistic
market setting; it is mainly characterized by fall in output,
income and employment with the rise in price level. Cost-push
inflation occurs due to increase in cost of production of goods and
services in the economy. Cost-push theories of inflation largely
attribute inflation to non-monetary, supply-side effects that
change the unit cost and profit markup components of the prices of
individual products. Sometimes costs may increase simply due to
economic booming; for example, increase in general wages because of
rapid expansion in demand. The cost of production can be increased
if there is wage rate increment from the trade union power
proportion compared to the increase in the marginal productivity of
the labor. The factor may be the increase in the oil prices.
Due to the increase in cost of production or supply constraints,
the Aggregate Supply (AS) curve shifts leftward from AS1 to AS2 to
AS3. Consequently, the prices increase from P1 to P2 to P3 thereby
leading to decline in output from y1 to y3. A series of increase in
cost of production will results in series of upward shift in
aggregate supply curve leading to inflationary rise in price.
The main causes of cost-push inflation are:
Increase in wage rate:
The trade unions of Nepal are so strong that they possess some
monopoly power due to the political backup. These trade unions are
able to raise wages by pressuring the entrepreneurs to grant them
increase in money wage in excess of increase in labor productivity.
This results in increase in cost of production. Thus inflationary
spiral goes on.
Profits: With the motive of increasing profit, Nepalese
entrepreneurs increase their profit margin level. Entrepreneurs
increase their profit by charging higher price for the commodity.
As a result the cost of production increases and inflation occurs.
Indirect Taxes:
Increase in indirect taxes in Nepal like excise duty, custom
duty increases the cost of living and push up the prices of
products. For example, prices of consumer durables, like electronic
goods, rise because of higher excise duty and increase the cost of
production. Likewise removal of government subsidies means the
people have to pay full price or high price.
Hoarding:
Hoarding of commodities, especially by the Nepalese traders by
the traders for profiteering, is also responsible for rise in
prices. During the period of scarcity and rising prices, traders,
merchants and even consumers indulge in hoarding of commodities;
goods go underground and this adds to the problem of scarcity and
rise in prices.
3.3 EXCHANGE RATE
The rate at which one currency may be converted into another is
known as the exchange rate. The exchange rate of the Nepal is
pegged with the India. India is the growing economy and the
currency of Indian currency is appreciating. When currency
appreciates it will create upward pressure in general price level.
Around 80% of Nepals import is from India. Finally Nepals import
become costlier and price level in Nepal raises.
3.4 INTERNATIONAL REASON
In the modern world, the economy of a country is linked with
other countries. The countries like Nepal are dependent on foreign
countries for construction materials, raw materials, energy
including consumer goods. Hence, if the price consumer goods raw
material and capital goods increases in foreign countries, the
price in Nepal also automatically increases. If the prices raises
due to price rise by foreign countries such as price of oil by
OPEC.
3.5 OTHER CAUSES
1. Consumption Habit: In general, the consumption habit of Nepal
is more westernized every day. In an economy where more than 65% of
the population is below 35 years of age, the younger generations
are a way ahead in purchasing consumer durables and canned food
items.
2. Heavy Tax Rate: Heavy tax rate is charged on luxurious
products especially automobiles as well as in the liquor and in
tobacco in Nepal. This increases the price level of the product.
Hence increase the inflation.
3. Increasing Foreign Reserve: Increase in level of foreign
currency reserve increases the broad money supply (M2). When money
in agricultural lands have been degraded due to natural
calamities.
4. Banks: The number of bank and financial institution are
increasing day by day. This helps to increase the credit
availability to the general public. When credit availability
increases, the general price level rises.
5. Growing concrete jungles:At present time all we see around us
are concrete buildings. Fertile lands have been used for real
estate purpose. If this trend goes on for a long time, we can
clearly predict that the inflation rate is undoubtly going to rise
especially for food items.
6.High labor cost:The prices of items are also high because of
the labor costs is very low mainly in terms of people who get paid
on daily basis.
7.Transportation charges:Transport entrepreneurs have ganged up
to overprice transportation costs because of rise in price of
petroleum products.
8. Price of petroleum products:Price of petroleum products has
been adjusted several times on the higher side. Such adjustments
helped pushing the cost of freight and carriages and cost of other
goods and services.
9. Transmission through trade:Furthermore, rising inflation in
India is transmitted in Nepal through trade, which is one of the
significant factors of increasing inflation rate of Nepal.
10.Seasonal constraints:Seasonal constraints also prompted to
push the inflation up in the past. For example, price rise on sugar
and sugar.
Inflation Control Measures in Nepal
In view of the serious consequences of inflation, it is
essential that inflation must be effectively controlled before it
assumes such a serious proportion that it threatens the very
existence of the economic and political system of the country.
Some of the control measures are discussed below:
1. Monetary Measures
Monetary policy aims at controlling the supply of money by
influencing in availability and cost of bank money or bank credit.
Central bank entrusted with the task of enforcing the monetary
policy. It is essential to adopt restrictive or dear monetary
policy to combat inflation. Restrictive monetary policy is
characterized by reducing the availability of bank credit and
increasing the cost of credit.
Two types of instruments can be adopted to implement
anti-inflationary and restrictive monetary policies, which are
discussed below:
Quantitative Measures
Quantitative measures aim at influencing the overall
availability of bank credit and its cost. Open market operations,
bank rate and legal reserve ratio are the main quantitative credit
control measures. As part of open market operations, the central
bank is required to sell government securities to the public and
financial institutions so as to reduce the cash reserve of the
commercial banks. Similarly, the central the minimum reserve ratio
which the commercial banks are required to keep with the central
bank. An increase in the legal reserve ratio will reduce the cash
reserves of the commercial banks. The fall in the cash reserves of
the commercial banks will force them to reduce their total advances
and loans.Another measure which can be adopted by the central bank
to control inflation is to increase the bank rate by the commercial
banks in their loans and advances. This will reduce the amount of
loans taken be the customers of the commercial banks as the lending
becomes costly.
Selective credit control measuresSelective credit control
measures aim at influencing the purpose for which bank credit is
made available and thereby affect the direction of bank credit. The
central bank can increase the margin requirements in case of
certain commodities as to reduce the amount of bank credit
available to the traders dealing in those commodities. Similarly,
the central can issue directives to the commercial banks
prohibiting them from lending against certain commodities or it
certain regions so as to curb inflationary pressures in selected
economic activities. In the same way, central bank can reduce the
bank credit to the consumers for the purchase of durable consumer
goods by regulating the consumer credit. The central bank can also
advise, appeal and persuade the commercial banks by using moral
suasion to achieve the same purpose.
The effectiveness of the monetary policy depends upon the extent
of control which the central bank has on the money market and the
degree of cooperation which it can get from the commercial banks
and the commercial banks and other financial institutions. However,
monetary policy is not very effective in curbing inflation,
particularly in developing countries.
2. Fiscal measuresFiscal policy also can be used to control
inflation. Fiscal policy is the policy of the government revenue.
Contractionary fiscal policy policy can be used to reduce the
aggregate demand and thereby control demand pull inflation.
Contractionary fiscal policy is the policy of reducing government
expenditure and increasing government revenue. The main tools of
fiscal policy are:
Public expenditure
Public expenditure i.e. expenditure by government is an
important component of aggregate demand. In order to control
inflation it is essential that government expenditure must be
reduced. However, part of the government expenditure is of
essential nature and, hence , cannot be reduced. Therefore, what is
important is that unproductive expenditure of the government, which
to some extent is non essential in nature, must be reduced. For
example, expenditure on defense and unproductive works should be
reduced.
Taxation
The major plank of anti- inflationary fiscal policy is to
increase the tax burden by increasing the tax rate and by imposing
new taxes. But direct and indirect taxes can be used for this
purpose. Direct taxes like income tax, corporate tax, etc reduce
the disposable income of the taxpayers and thereby reduce their
consumption expenditure. Indirect taxes like sales,tax, excise
duties, etc reduce the aggregate demand by making the commodities
expensive. In particular, while heavy indirect taxes need to be
imposed on those commodities which are consumed mainly by the rich
people, some amount of taxes should also be imposed on commodities
of mass use.
Public borrowing
Public borrowing enables the government to meet its expenditure
and thereby reduces the need for deficit financing. Moreover,
public borrowings help in reducing the amount of purchasing power
and thereby total demand in the economy. However, if people give
loans to the government out of their savings rather than by
curtailing their expenditure, the total demand may not fall.
Thus, a decrease in government expenditure and increase in
governments revenue producing a surplus budget is a type of fiscal
policy which can be used to control inflation.
3. Direct control measures
i) Price control and rationing
A direct measure to control inflation is to introduce price
controls and rationing of essential goods. Under price control
policy, the government fixes the maximum price at which certain
commodities could be sold. Since, the maximum price is set below
the free market equilibrium price; price ceiling is likely to
create scarcity of commodity. Therefore, price control policy is
often accompanied by rationing. Under rationing a specified
quantity of goods is given to the consumers at controlled price.
Price controls and rationing may be an effective policy in
controlling inflation. However, there are various practical
difficulties in implementing this policy. Firstly, price controls
and rationing can be introduced on a limited scale for a few
commodities only. Secondly, price control is likely to give rise to
black market. Black market is the market where goods are sold
unlawfully at higher prices than the controlled price.
ii) Increasing the availability of goods
The basic solution to the problem of inflation is to increase
the availability of goods in the economy. The following measures
need to be taken to increase the availability of goods:
Production should be increased. More specifically, production of
inflation- sensitive goods need to be increased by allocating more
resources, providing subsidies and removing bottlenecks impeding
production of these goods.
Domestic production of essential goods may be supplemented by
imports of these goods so as to reduce shortages and minimize
inflationary pressures.
iii) Indexation
Economists agree that if inflation is to be controlled, its
adverse effects on different groups of the society should be
minimized. They suggest indexation of prices, wages and contractual
obligations with a view to compensating those who lose their real
incomes due to inflation. It is defined as a mechanism at which
wages, prices and contracts are partly or wholly compensated for
changes in the general price level. It is a method of adjusting
monetary incomes so as to minimize the undue gains or losses in
real incomes of the different sections of the society due to
inflation.
P1
P3
P2
AS1
_1450725295.xlsChart1
7.70.1964
13.2260.7177
10.512-0.2052
9.6-0.0866
7.5-0.21875
Inflation, average consumer prices
Percent Change
Sheet1
YearInflation, average consumer pricesPercent Change
20087.719.64%
200913.22671.77%
201010.512-20.52%
20119.6-8.66%
20127.5-21.88%
Sheet1
Inflation, average consumer prices
Percent Change
Sheet2
Sheet3