Key Concepts in Economics: Money, Inflation, and Fiscal Policy

Posted on Dec 13, 2024 in Economy

Credit Creation by Commercial Banks

A commercial bank is a dealer of credit. It creates money based on cash deposits. Further, it issues new money through its loan operations and creates credit or expands the monetary base of a country. Therefore, this process of credit creation leads depositors to believe that they have money with the bank. Also, borrowers believe that they owe a certain amount of money to the bank.

Limitations of Credit Creation

The multiple credit creation process, as explained in the example above, depends on various factors:

  1. A lot depends on the Cash Reserve Ratio (CRR). In fact, there is an inverse relationship between the CRR and the size of the multiplier. Therefore, if the CRR is 100%, then the bank cannot create credit.
  2. What happens when a society is in an economic depression? People stop taking loans. If a bank cannot lend, then it cannot create credit. In other words, the credit creation depends on the amount of loans that a bank grants.
  3. The size of the cash deposit is an important factor too. If a bank has a smaller cash base, then it has a lesser scope for creating credit.
  4. A commercial bank lends money against accepted securities. The bank specifies the securities against which it offers loans. Also, the value of the securities must be equal to the amount of the loan. Even if the bank has a large cash base for creating credit, it will not lend money if it does not get acceptable security.
  5. The Central Bank (Reserve Bank of India) substantially controls the credit-creating power of all commercial banks. It has certain instruments which enable it to increase or decrease the volume of credit creation. Further, it also controls the direction and purpose of credit that the banks offer. All banks accept the regulations of the Central Bank as it is their lender of last resort.

Credit creation by commercial banks has several limitations, including:

  1. Risk of default: If borrowers do not repay their loans, banks can experience financial losses and non-performing assets (NPAs).
  2. Economic instability: Excessive credit creation can lead to inflation, asset bubbles, and speculative behavior in financial markets.
  3. Cyclical nature: During economic downturns, banks may become more risk-averse and reduce lending, which can amplify economic cycles.
  4. Liquidity concerns: If a large number of depositors demand their funds at the same time, banks may not have enough reserves to meet the withdrawal demands. This can lead to a financial crisis.
  5. Interest rate risk: Fluctuations in interest rates can impact a bank’s profitability. If interest rates rise, banks may face higher borrowing costs, which can affect their net interest margins.
  6. Cash Reserve Ratio (CRR): The size of the multiplier is inversely related to the CRR. If the CRR is 100%, the bank cannot create credit.
  7. Fiscal and monetary policy: Fiscal and monetary policy limit the power of commercial banks to create credit.

Credit creation is the process by which commercial banks expand the money supply in an economy by extending loans and advances to customers.

Quantity Theory of Money

The Quantity Theory of Money seeks to explain the factors that determine the general price level in an economy. According to this theory, the supply of money directly determines the price level. In this article, we will look at the Transaction Approach and the Cash Balance Approach of the Quantity Theory of Money.

Fisher gave the Transaction Approach to the Quantity Theory of Money. The following equation of exchange explains it:

MV = PT

Where:

  • M – The total supply of money
  • V – The velocity of the circulation of money
  • P – The general price level
  • T – The total transactions in physical goods

In simple words, this equation means that in an economy, the total value of all goods sold during any period (PT) is equal to the total quantity of money spent during that period (MV).

Assumptions of Quantity Theory of Money

  1. The price level is measured over a period of time.
  2. There are no credit sales in the market.
  3. Money is only a medium of exchange.
  4. Each unit of money can change hands several times during the said time interval.
  5. All cash payments received during the year are equal to the volume of goods and services sold multiplied by their respective prices.

Monetary Measures to Control Business Cycle

Central banks use monetary policy to control a country’s economy and influence business cycles through interest rates and money supply. Some monetary measures that central banks use include:

  1. Open market operations: The buying and selling of government securities.
  2. Discount rate: The interest rate charged by central banks for short-term loans.
  3. Reserve requirements: The portions of deposits that banks must maintain.

Monetary policy can impact business cycles in the following ways:

  1. Lower interest rates: Can boost growth.
  2. Tightening monetary policy: Can lead to a contraction.
  3. Contractionary monetary policy: A common method of managing inflation.

Monetarist theory is an economic theory that states that central banks have a lot of power over economic growth rates because they control monetary policy.

Effects of Inflation on Production and Distribution

Inflation can affect production and distribution in a number of ways, including:

  • Production: Inflation can increase the production of goods and services because producers are motivated by higher profits. However, production can eventually stop when all resources are used up. Other effects of inflation on production include:
    1. Misallocation of resources: Producers may divert resources from essential goods to non-essential goods.
    2. Reduced production: Uncertainty about rising prices and input costs can reduce production.
    3. Fall in quality: Producers may produce sub-standard commodities or adulterate commodities.
  • Distribution: Inflation can affect distribution in a number of ways, including:
    1. Income distribution: Inflation can increase inequality in income distribution. People with fixed incomes, such as salaried individuals and pensioners, experience a fall in real income and purchasing power.
    2. Business profits: Businessmen and entrepreneurs experience an increase in profits.
    3. Landlords: Landlords lose during rising prices because they get fixed rents.
    4. Peasant proprietors: Peasant proprietors who own and cultivate their farms gain because prices of farm products increase more than the cost of production.

What is Inflation?

Inflation is a gradual increase in the prices of goods and services over time, which reduces the purchasing power of a currency. This means that the same amount of money can buy fewer goods and services than it could in the past.

Consequences of Inflation

  1. Loss of purchasing power: The most obvious effect of inflation is that people have less purchasing power.
  2. Higher interest rates: Inflation can lead to higher interest rates in the long run.
  3. Lower exports: When prices are higher, other countries may find it less attractive to buy goods from the country experiencing inflation.
  4. Economic growth slows: Inflation can slow economic growth.
  5. Anti-inflationary measures can cause a recession: Anti-inflationary measures can cause a recession.

Inflation can be caused by a number of factors, including demand-pull inflation, cost-push inflation, increased money supply, currency devaluation, and government policies and regulations.

The inflation rate is calculated by averaging the price increase of a basket of selected goods and services over a year. The most common measure of inflation is the consumer price index (CPI).

Trade Cycle and its Stages

The “trade cycle” refers to the naturally occurring cyclical variations in economic activity that occur in economies. The cycle is described by phases of expansion, peak, contraction, and trough. Business or trade cycles are the terms used to describe the cyclical expansion and contraction of economic activity. The period of Expansion, Upswing, or Prosperity refers to the era of high income, high output, and high employment. The era of contraction, recession, downswing, or depression is a time of low income, poor production, and low employment.

Phases of Trade Cycle

The four different phases of the trade cycle are referred to as:

  1. Boom
  2. Recession
  3. Depression
  4. Recovery

Boom or Prosperity Phase

The full employment and the movement of the economy beyond full employment is characterized as a boom period.

  1. During this period, there is hectic activity in the economy.
  2. Money wages rise, profits increase and interest rates go up.
  3. The demand for bank credit increases and there is all-around optimism.

Recession

  1. The turning point from the boom condition is called recession.
  2. This happens at a higher rate than what was earlier.
  3. Generally, the failure of a company or bank bursts the boom and brings a phase of recession.
  4. Investments are drastically reduced, production comes down and income and profits decline.
  5. There is panic in the stock market and business activities show signs of dullness.
  6. The liquidity preference of the people rises and the money market becomes tight.

Depression

  1. During the depression, the level of economic activity becomes extremely low.
  2. Firms incur losses and closure of business become a common feature and the ultimate result is unemployment.
  3. Interest prices, profits, and wages are low.
  4. The agricultural class and wage earners would be the worst hit.
  5. Banking institutions will be reluctant to advance loans to businessmen.
  6. Depression is the worst phase of the business cycle.
  7. The extreme point of depression is called a “trough” because it is a deep point in the business cycle.

Recovery

  1. After a period of depression, recovery sets in.
  2. This is the turning point from depression to revival towards an upswing.
  3. It begins with the revival of demand for capital goods.
  4. Autonomous investments boost the activity.
  5. The demand slowly picks up and in due course, the activity is directed towards the upswing with more production, profit, income, wages, and employment.

What is Public Debt?

Public debt meaning: It is the total amount of money that is owed to the public by the government to meet the development funds. In public finance, it is also known as public interest, government debt, national debt, and sovereign debt. The public debt can also be owed to lenders within the country. Even foreign leaders can owe money to the public, but this type of debt is called external debt. By handing out government bonds and bills, the government can create public debt.

Importance of Public Debt

Public debt can be important for a government to achieve its goals, but it can also lead to problems if it is not managed properly:

  1. Economic growth: When used wisely, public debt can help a government grow its economy.
  2. Social and developmental goals: Public debt can help a government achieve its social and developmental goals.
  3. Avoids bankruptcy: Public debt can help a government avoid bankruptcy.
  4. Discourages wasteful spending: Public debt can help a government avoid making wasteful expenditures.
  5. Builds trust: Public debt can help build trust with debtors.
  6. Makes future debt issuance easier: Public debt can make it easier for a government to issue debt in the future.
  7. Reduces debt management costs: Public debt can help a government reduce the cost of managing debt.
  8. Helps save on taxes: If debt is paid early, it can help a government save on future taxes.
  9. Balance sheet risk: A government’s debt portfolio can be its largest financial portfolio, and it can create balance sheet risk.
  10. Vulnerability to economic shocks: A large and poorly structured debt portfolio can make a government more vulnerable to economic and financial shocks.
  11. Inflation: High levels of debt can lead to higher inflation rates.
  12. Financial instability: High levels of debt can lead to financial instability.
  13. Financial asset prices: High levels of debt can affect the prices of financial assets.

Quantitative Tools of Credit Control

Quantitative tools of credit control include:

  1. Cash Reserve Ratio: The central bank can lower the cash reserve ratio to increase the cash reserves of commercial banks and create credit.
  2. Statutory Liquidity Ratio (SLR): The SLR is the percentage of deposits that commercial banks must keep in liquid assets, such as cash, gold, or government securities. The central bank can change this ratio to affect the amount of money that commercial banks can lend.
  3. Bank rate: The central bank can increase the bank rate as a direct instrument of credit control. Credit control is a monetary policy tool used by the Reserve Bank of India to control the money supply and liquidity in the economy.

There are also qualitative credit control measures, such as selective credit controls and moral suasion.

  1. Selective credit controls: A qualitative tool that restricts credit and expands it for priority sectors.
  2. Moral suasion: The central bank issues directives, guidelines, and suggestions to commercial banks to reduce credit supply for speculative purposes.

What is Public Expenditure?

Public expenditure refers to expenditure by different levels of governments—local, regional, or national—on goods, services, and transfers. This includes spending on infrastructural development, education, health care, and national defense, social welfare programs, and administrative costs. Public expenditure is the key element in fiscal policy that is put in place to help in achieving economic, social, and developmental objectives for a country. Governments use public funds to finance things that are paramount in the running of an economy, ensuring its growth by promoting the general welfare of the people, and also ensuring that the societal needs are satisfied.

Public expenditure refers to the expenditure incurred by the public authority (i.e., Central, State, and Local Bodies) for the protection of their citizens, for satisfying their collective needs, and for promoting their economic and social welfare.

Causes for Increasing Public Expenditure

There is a continuous growth in public expenditure in developing countries like India due to various reasons as follows:

  1. Increase in the Activities of the Government: These functions include the spread of education, public health, public works, public recreation, social welfare schemes, etc. It is observed that new functions are continuously being undertaken and old functions are being performed more efficiently on a large scale by the government. This leads to an increase in public expenditure.
  2. Rapid Increase in Population: The population of developing countries like India is increasing fast. In the 2011 Census, it was 121.02 crores. As a result, the government has to incur greater expenditure to fulfill the needs of the increasing population.
  3. Growing Urbanization: Rapid spread of urbanization is a global phenomenon of the day. This leads to an increase in the government expenditure on water supply, roads, energy, schools and colleges, public transport, sanitation, etc.
  4. Increasing Defence Expenditure: In modern times, the defense expenditure of the government is increasing even in peacetime due to unstable and hostile international relationships.
  5. Spread of Democracy: The majority of the countries in the world are democratic in nature. A democratic form of government is expensive due to regular elections and other such activities. It results in an increase in the total expenditure of the government.
  6. Inflation: Just like a private individual, the government has to buy goods and services from the market for the spread of economic and social development. Normally, prices show a rising trend. Due to this, the government has to incur increasing costs.
  7. Industrial Development: Industrial development leads to an increase in production, employment, and overall growth in the economy. Hence, the government makes huge efforts for implementing various schemes and programs for industrial development. This results in an increase in government expenditure.
  8. Disaster Management: Many natural and man-made calamities like earthquakes, floods, cyclones, social unrest, etc. are occurring more frequently. The government has to spend a huge amount on disaster management which increases total expenditure.

Modern governments are working for ‘welfare states’. Hence, there is a continuous increase in public expenditure.

Demand-Pull Inflation

Demand-pull inflation occurs when the demand for goods and services in an economy exceeds their supply. This imbalance between high demand and insufficient supply leads to a general rise in prices. It is a common phenomenon in growing economies where consumer and business spending accelerates faster than the production capacity of the economy.

Causes

Increased Consumer Spending

One of the primary causes of demand-pull inflation is increased consumer spending. When individuals and households have more disposable income, they tend to spend more on goods and services. This surge in demand can outstrip supply, leading to higher prices.

Government Expenditure

Government spending on infrastructure projects, defense, and social programs can also lead to demand-pull inflation. When the government injects large amounts of money into the economy, it boosts overall demand. If this increased demand is not matched by an increase in supply, prices will rise.

Foreign Demand

An increase in foreign demand for a country’s goods and services can contribute to demand-pull inflation. When exports rise significantly, the domestic supply of goods decreases, leading to higher prices for the remaining goods available in the domestic market.

Deficit Budget

A budget deficit occurs when expenditures surpass revenue and then impact the financial health of a country. The term budget deficit is generally used when talking about total economic spending rather than the budget of businesses or individuals. National debt is made of the accrued deficits in the budget.

Types of Budget Deficit

There are three types of budget deficit. They are:

  • Fiscal Deficit
  • Revenue Deficit
  • Primary Deficit

Calculating Budget Deficit

Budget Deficit = The Total Expenditures by the Government − The Total Income of the Government

The total income of the government involves corporate taxes, personal taxes, stamp duties. Total expenditure consists of the expense in defense, energy, science, healthcare, social security, etc.

Functions of Money

The first and the leading role of money is to function as a mode of exchange. Barter exchanges become exceptionally tough in a large economy because of the high prices, people would have to sustain looking for proper people to exchange their excesses or surpluses. Money also functions as a suitable unit of account. The value of all the commodities and services can be expressed in monetary terms. If the cost prices of all goods go up in monetary terms, i.e., there is a general rise in the cost price degree, the value of money in terms of any good must have come down – in the sense that a unit of money can now buy less of any good. We call it a decline or deterioration in the buying power of money. The barter system has other dearths and deficiencies. It is tough to carry forward one’s opulence under the barter system.

Cost-Push Inflation

Explanation

Cost-push inflation is a type of inflation that occurs when the cost of production increases, causing prices to rise. When the cost of production increases, businesses are forced to raise prices to maintain their profit margins. This can be caused by a number of factors, such as higher wages, raw materials, or energy costs.

Effects

Cost-push inflation can lead to a general increase in prices across the economy. For example, if the price of oil increases, it can lead to higher petrol prices, which can then make it more expensive to transport goods, resulting in higher prices for other items.

Causes

Cost-push inflation can be caused by a number of factors, including:

  1. Supply disruptions: Natural disasters, such as floods, cyclones, or overfishing, can limit supply and cause inflation.
  2. Labor costs: A rise in labor costs can lead to cost-push inflation.
  3. Taxes: An increase in taxes can cause cost-push inflation.
  4. Exchange rate: A fall in the external value of the exchange rate can lead to a rise in prices of imported products.

Money Supply Measurement by the Reserve Bank of India

The Reserve Bank of India (RBI) measures money supply using four monetary aggregates: M1, M2, M3, and M4. These aggregates are used to analyze and manage the money supply. The money supply is the total amount of currency and liquid assets in an economy on a given date. It includes all coins, notes, and demand deposits held by the public. However, money that is kept as stock with the central bank or government is not included in the money supply.

The different aggregates provide unique insights into the money supply:

  • M1: Focuses on the most liquid and spendable forms of money.
  • M2: Includes less liquid assets to provide a broader view of how money flows through the economy.
  • M3: Includes term deposits of residents with a contractual maturity of over one year with the Banking System.

Understanding the money supply is important because it directly affects inflation, interest rates, and economic growth.

Surplus Budget

A surplus budget is when a government or corporation has more money coming in than going out. This can be a sign of effective financial management and can allow for additional funds to be reinvested or used to pay off debt.

Other things to know about a surplus budget

  • Opposite of a deficit: A budget deficit occurs when spending exceeds income.
  • Benefits: A surplus budget can help to combat inflation and lower prices. It can also help to ensure financial stability and avoid wasteful spending.
  • Individuals: For individuals, excess income is referred to as savings, not a budget surplus.

Stagflation

Stagflation is an economic condition where a country experiences high inflation, high unemployment, and stagnant economic growth at the same time. The term is a combination of the words “stagnation” and “inflation”. Stagflation is challenging for economic policymakers to manage because trying to correct one factor can make another worse. There is no universal agreement on how to stop stagflation, and the standard macroeconomic remedies for inflation or unemployment are ineffective.

Stagflation is often caused by supply shocks. A well-known example of stagflation occurred in the 1970s during the oil crisis. The Organization of Petroleum Exporting Countries (OPEC) embargoed oil exports to Western countries that supported Israel in the Yom Kippur War.

Stagflation challenges traditional economic theories, which previously suggested that inflation and unemployment were inversely related. During periods of economic expansion, demand is expected to drive up prices, which encourages businesses to grow and hire more employees. During a recession, lower demand traditionally leads to unemployment, lower inflation, and capped price increases.