CHAPTER 02 – INFLATION AND ITS CONTROL

Syllabus: Monetary Policy, Fiscal Policy, Problems and Limitations of

Monetary Policy in an Undeveloped Country, Inflation and Deflation

Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and,
subsequently, purchasing power is falling. Central banks attempt to stop severe inflation,
along with severe deflation, in an attempt to keep the excessive growth of prices to a
minimum.

The overall general upward price movement of goods and services in an economy (often
caused by a increase in the supply of money), usually as measured by the Consumer Price
Index and the Producer Price Index. Over time, as the cost of goods and services increase,
the value of a dollar is going to fall because a person won't be able to purchase as much with
that dollar as he/she previously could. While the annual rate of inflation has fluctuated
greatly over the last half century, ranging from nearly zero inflation to 23% inflation, the Fed
actively tries to maintain a specific rate of inflation, which is usually 2-3% but can vary
depending on circumstances. It is opposite of deflation.

Inflation is defined as a sustained increase in the general level of prices for goods and
service. It is measured as an annual percentage increase. As inflation rises, every dollar you
own buys a smaller percentage of a good or service.

Causes of Inflation

Inflation is a normal economic phenomenon that should happen at a pre-determined speed

anything above that should be a cause of concern. CPI or consumer price index is the most
common gauge of inflation which measure the price increase and decrease of basic goods
and services. Following are some of the reasons that causes Inflation -

1. Excess printing of money

2. Rise in production and labor costs
3. High lending levels & Currency devaluation
4. High level of taxes
5. Unemployment

Excess Printing of Money: The general cause of inflation that has been agreed among most
economists is when there is an increase in the money supply or a decrease in the quality of
goods being supplied. Money supply plays a larger role in inflationary pressure, the more
money injected in the economy the more will be the inflation.

Rise in Production and Labor Costs: Another cause of inflation that should be kept in
mind is a rise in the production cost that leads to an increase in the prices of the end
products. Expensive Raw Material leads to an increase in the production cost that ultimately
results in the company increasing prices of the final product to maintain steady profits.
Rising labor costs can also lead to inflation. As workers demand wage increases, companies
usually chose to pass on those costs to their customers.

High Lending Levels & Currency Devaluation: High lending levels are a curse to any
nation and can result in an increasing level of Inflation as International lending and national
debts have to be paid off with an addition of interest, which ultimately end up soaring prices
in the country as a way to keep up with the debts. This causes the exchange rate to drop
which results in more inflation, as government has to deal with the gap created between the
import/export levels.

High Level of Taxes: An increase in federal taxes either direct or indirect put on consumer
products lead to inflation as suppliers transfer the burden to the consumer. A classic example
of this cost-push or supply-stock inflation is the 1970s oil crisis after OPEC raised prices and
as a result US saw double digit inflation levels during that period. As oil is used commonly a
sharp rise leads to an increase in the prices of all commodities. Law & order situation and
wars can often cause Inflation as the government has to repay the funds taken from the
central bank. The impact of ways can be seen on everything from international trading to
labor costs to product demand, so at the end it always inflates prices.

Unemployment: A connection between inflation and unemployment has been drawn since
the emergence of large scale unemployment in the 19th century, and connections continue to
be drawn today. In Marxian economics, the unemployed serve as a reserve army of labor,
which restrain wage inflation. In the 20th century, similar concepts in Keynesian economics
include the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and the Phillips
curve.
Finally, a steady level of Inflation should be maintained as it shows the growth of an
economy but any rise at an unsustainable level will certainly have a bad impact on the
economy just as it happens in 2008 with a global price rise in oil, food, steel and other
commodities.

Thus, the cause of Inflation which may be due to:

1. Increase in money supply

2. Increase in disposable income
3. Increase in community’s aggregate spending on consumption and investment goods
4. Excessive speculation and tendency to hoarding and profiteering on the part of
procedures and traders
5. Increase in foreign demand and hence exports
6. Increase in salaries, wages or dearness allowance; and
7. Increase in population

Cost Push Inflation

Cost-push inflation occurs when businesses respond to rising production costs, by raising
prices in order to maintain their profit margins. There are many reasons why costs might
rise:
 • Rising Imported Raw Materials Costs perhaps caused by inflation in countries that
are heavily dependent on exports of these commodities or alternatively by a fall in the
value of the pound in the foreign exchange markets which increases the UK price of
imported inputs. A good example of cost push inflation was the decision by British
Gas and other energy suppliers to raise substantially the prices for gas and electricity
that it charges to domestic and industrial consumers at various points during 2005 and
2006.
• Rising Labor Costs: caused by wage increases which exceed any improvement in
productivity. This cause is important in those industries which are ‘labor-intensive’.
Firms may decide not to pass these higher costs onto their customers (they may be
able to achieve some cost savings in other areas of the business) but in the long run,
wage inflation tends to move closely with price inflation because there are limits to the
extent to which any business can absorb higher wage expenses.
• Higher Indirect Taxes Imposed by the Government: for example a rise in the rate
of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in
the standard rate of Value Added Tax or an extension to the range of products to
which VAT is applied. These taxes are levied on producers (suppliers) who,
depending on the price elasticity of demand and supply for their products, can opt to
pass on the burden of the tax onto consumers. For example, if the government was to
choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-
push inflation.

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply
curve. This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a
contraction of real national output together with a rise in the general level of prices.

Demand Pull Inflation

Demand-pull inflation is likely when there is full employment of resources and when SRAS
is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD
might rise for a number of reasons – some of which occur together at the same moment of
the economic cycle –

• A depreciation of the Exchange Rate, which has the effect of increasing the price of
imports and reduces the foreign price of UK exports. If consumers buy fewer imports,
while foreigners buy more exports, AD will rise. If the economy is already at full
employment, prices are pulled upwards.
• A Reduction in Direct or Indirect Taxation. If direct taxes are reduced consumers
have more real disposable income causing demand to rise. A reduction in indirect
taxes will mean that a given amount of income will now buy a greater real volume of
goods and services. Both factors can take aggregate demand and real GDP higher and
beyond potential GDP.
• The Rapid Growth of the Money Supply – perhaps as a consequence of increased
bank and building society borrowing if interest rates are low. Monetarist economists
believe that the root causes of inflation are monetary – in particular when the
monetary authorities permit an excessive growth of the supply of money in circulation
beyond that needed to finance the volume of transactions produced in the economy.
 • Rising Consumer Confidence and an Increase in the Rate of Growth of House
Prices – both of which would lead to an increase in total household demand for goods
and services
• Faster Economic Growth in other Countries – providing a boost to UK exports
overseas.

Deflation

In common usage deflation is generally considered to be "falling prices". But there is much
more to it than that. Often people confuse deflation with disinflation or with Depression (as
in "the Great Depression"). These three terms are related but not synonymous.

Deflation is a general decline in prices, often caused by a reduction in the supply of money
or credit. Deflation can be caused also by a decrease in government, personal or investment
spending. The opposite of inflation, deflation has the side effect of increased unemployment
since there is a lower level of demand in the economy, which can lead to an economic
depression. Central banks attempt to stop severe deflation, along with severe inflation, in an
attempt to keep the excessive drop in prices to a minimum.

In economics, deflation is a decrease in the general price level of goods and services.
Deflation occurs when the annual inflation rate falls below 0% (a negative inflation rate).

There are four causes for Deflation –

1. Decreasing Money Supply

2. Increasing Supply of Goods
3. Decreasing Demand for Goods
4. Increasing Demand for Money

Is Deflation Good or Bad?

Actually, deflation itself is neither good nor bad. It depends on the cause of the deflation
whether people will suffer or rejoice. If the cause is increasing supply of goods that would be
good. Another example of this is in the late 1800's as the industrial revolution dramatically
increased productivity.

However, if deflation is caused by a decreasing supply of money as in the great depression,

that would be bad. The stock market crash sucked all the liquidity out of the market place,
the economy contracted, and people lost their jobs and then banks stopped loaning money
because people were defaulting. The problem compounded as more people lost their jobs
and money supply fell further causing more people to lose their jobs, etc. etc.

Note: During the Depression demand for money was high (but no one could afford it)
because supply was low.
So deflation can be caused by several different things and thus can be good or bad depending
on the cause.
Benefits of Price Stability

The objective of price stability refers to the general level of prices in the economy. It implies
avoiding both prolonged inflation and deflation. Price stability contributes to achieving high
levels of economic activity and employment by
• Improving the transparency of the price mechanism. Under price stability people can
recognize changes in relative prices (i.e. prices between different goods), without
being confused by changes in the overall price level. This allows them to make well-
informed consumption and investment decisions and to allocate resources more
efficiently;
• Reducing inflation risk premier in interest rates (i.e. compensation creditors ask for the
risks associated with holding nominal assets). This reduces real interest rates and
increases incentives to invest;
• Avoiding unproductive activities to hedge against the negative impact of inflation or
deflation;
• Reducing distortions of inflation or deflation, which can exacerbate the distortionary
impact on economic behaviour of tax and social security systems;
• Preventing an arbitrary redistribution of wealth and income as a result of unexpected
inflation or deflation.

Types of Inflation

When there is a rise in general price level for all goods and services it is known as inflation.
An inflationary movement could be because of the rise in any single price or a group of
prices of related goods and services.

There are four main types of inflation. The various types of inflation are briefed below.

• Wage Inflation: Wage inflation is also called as demand-pull or excess demand

inflation. This type of inflation occurs when total demand for goods and services in an
economy exceeds the supply of the same. When the supply is less, the prices of these
goods and services would rise, leading to a situation called as demand-pull inflation.
This type of inflation affects the market economy adversely during the wartime.
• Cost-push Inflation: As the name suggests, if there is increase in the cost of
production of goods and services, there is likely to be a forceful increase in the prices
of finished goods and services. For instance, a rise in the wages of laborers would
raise the unit costs of production and this would lead to rise in prices for the related
end product. This type of inflation may or may not occur in conjunction with demand-
pull inflation.
• Pricing Power Inflation: Pricing power inflation is more often called as administered
price inflation. This type of inflation occurs when the business houses and industries
decide to increase the price of their respective goods and services to increase their
profit margins. A point noteworthy is pricing power inflation does not occur at the
time of financial crises and economic depression, or when there is a downturn in the
economy. This type of inflation is also called as oligopolistic inflation because
oligopolies have the power of pricing their goods and services.
 • Sectoral Inflation: This is the fourth major type of inflation. The sectoral inflation
takes place when there is an increase in the price of the goods and services produced
by a certain sector of industries. For instance, an increase in the cost of crude oil
would directly affect all the other sectors, which are directly related to the oil industry.
Thus, the ever-increasing price of fuel has become an important issue related to the
economy all over the world. Take the example of aviation industry. When the price of
oil increases, the ticket fares would also go up. This would lead to a widespread
inflation throughout the economy, even though it had originated in one basic sector. If
this situation occurs when there is a recession in the economy, there would be layoffs
and it would adversely affect the work force and the economy in turn.
• Fiscal Inflation: Fiscal Inflation occurs when there is excess government spending.
This occurs when there is a deficit budget. For instance, Fiscal inflation originated in
the US in 1960s at the time President Lydon Baines Johnson. America is also facing
fiscal type of inflation under the president ship of George W. Bush due to excess
spending in the defense sector.
• Hyperinflation: Hyperinflation is also known as runaway inflation or galloping
inflation. This type of inflation occurs during or soon after a war. This can usually lead
to the complete breakdown of a country’s monetary system. However, this type of
inflation is short-lived. In 1923, in Germany, inflation rate touched approximately 322
percent per month with October being the month of highest inflation.
• Demand-pull Inflation: It is likely when there is full employment of resources and
when SRAS is inelastic. In these circumstances an increase in AD will lead to an
increase in prices. AD might rise for a number of reasons – some of which occur
together at the same moment of the economic cycle.
• R u n n i n g I n f l a t i o n : T h i s i nf l a t i on em er g es when the movements of price
accelerate rapidly. Running inflation may record more than 100 per cent rise in prices
over a decade. Thus, when prices rise by more than 10 per cent a year, running inflation
occurs. Economists have not described the range of running inflation. But, we may say
that a double digit inflation of 10-20 per cent per annum is a running inflation. If it
exceeds that figure, it may be called ‘galloping’ inflation.

To sum up, any type of inflation could affect the economy of a country badly.

Fiscal policy

Fiscal policy is a tool which is used by national governments to influence the direction of the
economy, generally with the goal of promoting economic health and growth. Fiscal policies
can be approached in a variety of ways, and they tend to vary as heads of state change,
because different people have their own approaches to economic issues. Nations must strike
a balance with their fiscal policies, so that they benefit the economy without being perceived
as too interfering.

The two main instruments of fiscal policy are government expenditure and taxation. Fiscal
policy involves the Government changing the levels of Taxation and Govt. Spending in order
to influence Aggregate Demand (AD) and therefore the level of economic activity.
Monetary Policy

The actions of a central bank, currency board or other regulatory committee that determine
the size and rate of growth of the money supply, which in turn affects interest rates.
Monetary policy is maintained through actions such as increasing the interest rate, or
changing the amount of money banks need to keep in the vault (bank reserves).

In other words, monetary policy is the regulation of the money supply and interest rates by a
central bank, such as the Federal Reserve Board in the U.S., in order to control inflation and
stabilize currency. Monetary policy is one the two ways the government can impact the
economy. By impacting the effective cost of money, the Federal Reserve can affect the
amount of money that is spent by consumers and businesses.

Monetary Policy involves changes in the base rate of interest to influence the rate of growth
of aggregate demand, the money supply and ultimately price inflation.

Monetary policy is one of the tools that a national Government uses to influence its
economy. Using its monetary authority to control the supply and availability of money,
a government attempts to influence the overall level of economic activity in line with its
political objectives. Usually this goal is "macroeconomic stability" - low
unemployment, low inflation, economic growth, and a balance of external payments.
Monetary policy is usually administered by a Government appointed "Central Bank",
the Bank of Canada and the Federal Reserve Bank in the United States.

Problem of Monetary Policy

The LDCs (Less Developed Countries) encounter greater Limitations than Developed
countries in using monetary and fiscal policies to achieve macroeconomic goals. The
banking system, often limited in its ability to regulate the money supply to influence output
and prices in developed countries, is even more ineffective in LDCs. Usually the money
market in developing countries is externally dependent, poorly organized, fragmented and
cartelized. The following are the major limitations of Monetary Policy in LDCs including
Pakistan:-

1. Many of the major Commercial Banks in LDCs are branches of large private banks in
developed countries, such as Chase Manhattan or Barclay's Bank. Their orientation is
external. They are concerned with profits in dollars, pound sterling, or other
convertible currency, not rupees, pesos and other currencies that cannot be exchanged
on the world market.’
2. Many LDCs are so dependent on international transactions that they must limit the
banking system's local expansion of the money supply to some multiple of foreign
currency held by the central bank. Thus the government can not always control the
money supply because of the variability of foreign exchange assets.
3. The LDC central banks do not have much influence on the amount of bank deposits.
They generally make few loans to commercial banks. Furthermore since securities
markets are usually not well developed in LDCs, the central bank usually buys and
sells few bonds on the open market.
 4. Commercial banks generally restrict their loans to large and medium enterprises in
modern manufacturing, mining, power, construction, transport and plantation
agriculture. Small traders, artisans, and farmers obtain most of their funds from close
relatives or borrow at …

Controlling Inflation

A variety of methods have been used in attempts to control inflation.

Today the primary tool for controlling inflation is monetary policy. Most central banks are
tasked with keeping the federal funds lending rate at a low level; normally to a target rate
around 2% to 3% per annum, and within a targeted low inflation range, somewhere from
about 2% to 6% per annum. A low positive inflation is usually targeted, as deflationary
conditions are seen as dangerous for the health of the economy.

There are a number of methods that have been suggested to control inflation. Central banks
can affect inflation to a significant extent through setting interest rates and through other
operations. High interest rates and slow growth of the money supply are the traditional ways
through which central banks fight or prevent inflation, though they have different
approaches. For instance, some follow a symmetrical inflation target while others only
control inflation when it rises above a target, whether express or implied.

Fixed Exchange Rates: Under a fixed exchange rate currency regime, a country's currency
is tied in value to another single currency or to a basket of other currencies (or
sometimes to another measure of value, such as gold). A fixed exchange rate is usually
used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can
also be used as a means to control inflation. However, as the value of the reference
currency rises and falls, so does the currency pegged to it.

Gold Standard: The gold standard is a monetary system in which a region's common media
of exchange are paper notes that are normally freely convertible into pre-set, fixed
quantities of gold. The standard specifies how the gold backing would be
implemented, including the amount of specie per currency unit. The currency itself
has no innate value, but is accepted by traders because it can be redeemed for the
equivalent specie. A U.S. silver certificate, for example, could be redeemed for an
actual piece of silver.
Wage and Price Controls: Another method attempted in the past has been wage and price
controls ("incomes policies"). Wage and price controls have been successful in
wartime environments in combination with rationing. However, their use in other
contexts is far more mixed. Notable failures of their use include the 1972 imposition
of wage and price controls by Richard Nixon.

In general wage and price controls are regarded as a temporary and exceptional measure,
only effective when coupled with policies designed to reduce the underlying causes of
inflation during the wage and price control regime, for example, winning the war
being fought. Artificially low prices often cause rationing and shortages and
discourage future investment, resulting in yet further shortages. The usual economic
analysis is that any product or service that is under-priced is over consumed.

Other Measures: Credit control, artificial money, de-monetarization of currency, issue of

new currency, fiscal measures, reduction of unnecessary cost, increase in cost,
increase in savings, increase in credit, surplus budget, deficit budget, public debt,
increase production, rational wage policy, price control and ratio nary.

Temporary controls may complement a recession as a way to fight inflation: the controls
make the recession more efficient as a way to fight inflation (reducing the need to increase
unemployment), while the recession prevents the kinds of distortions that controls cause
when demand is high.

Adapting to Inflation

Cost-of-living Allowance: The real purchasing-power of fixed payments is eroded by

inflation unless they are inflation-adjusted to keep their real values constant. In many
countries, employment contracts, pension benefits, and government entitlements (such
as social security) are tied to a cost-of-living index, typically to the consumer price
index.[59] A cost-of-living allowance (COLA) adjusts salaries based on changes in a
cost-of-living index. Salaries are typically adjusted annually in low inflation
economies. During hyperinflation they are adjusted more often. They may also be tied
to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future

percentage increases in worker pay which are not tied to any index. These negotiated
increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living
increases because of their similarity to increases tied to externally determined indexes. Many
economists and compensation analysts consider the idea of predetermined future "cost of
living increases" to be misleading for two reasons: (1) For most recent periods in the
industrialized world, average wages have increased faster than most calculated cost-of-living
indexes, reflecting the influence of rising productivity and worker bargaining power rather
than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but
instead compare current or historical data.

Effects of Inflation
Most effects of inflation are negative, and can hurt individuals and companies alike, below
are a list of negative and “positive” effects of inflation:

Negative effects are:

1. Hoarding (people will try to get rid of cash before it is devalued, by hoarding food and
other commodities creating shortages of the hoarded objects).
2. Distortion of relative prices (usually the prices of goods go higher, especially the
prices of commodities).
3. Increased risk - Higher uncertainties (uncertainties in business always exist, but with
inflation risks are very high, because of the instability of prices).
4. Income diffusion effect (which is basically an operation of income redistribution).
5. Existing creditors will be hurt (because the value of the money they will receive from
their borrowers later will be lower than the money they gave before).
6. Fixed income recipients will be hurt (because while inflation increases, their income
doesn’t increase, and therefore their income will have less value over time).
7. Increased consumption ratio at the early stages of inflation (people will be consuming
more because money is more abundant and its value is not lowered yet).
8. Lowers national saving (when there is a high inflation, saving money would mean
watching your cash decrease in value day after day, so people tend to spend the cash
on something else).
9. Illusions of making profits (companies will think they were making profits while in
reality they’re losing money if they don’t take into consideration the inflation rate
when calculating profits).
10. Causes an increase in tax bracket (people will be taxed a higher percentage if their
income increases following an inflation increase).
11. Causes mal-investment (in inflation times, the data given about an investment is often
deceptive and unreliable, therefore causing losses in investments).
12. Causes business cycles (many companies will have to go out of business because of
the losses they incurred from inflation and its effects).
13. Currency debasement (which lowers the value of a currency, and sometimes cause a
new currency to be born)
14. Rising prices of imports (if the currency is debased, then it’s purchasing power in the
international market is lower).

"Positive" effects of inflation are:

1. It can benefit the inflators (those responsible for the inflation)

2. It is benefit early and first recipients of the inflated money (because the negative
effects of inflation are not there yet).
3. It can benefit the cartels (it benefits big cartels, destroys small sellers, and can cause
price control set by the cartels for their own benefits).
4. It might relatively benefit borrowers who will have to pay the same amount of money
they borrowed (+ fixed interests), but the inflation could be higher than the interests,
therefore they will be paying less money back. (example, you borrowed $1000 in 2005
with a 5% fixed interest rate and you paid it back in full in 2007, let’s suppose the
inflation rate for 2005, 2006 and 2007 has been 15%, you were charged %5 of
 interests, but in reality, you were earning %10 of interests, because 15% (inflation
rate) – 5% (interests) = %10 profit, which means you have paid only 70% of the real
value in the 3 years.

Note: Banks are aware of this problem, and when inflation rises, their interest rates might
rise as well. So don't take out loans based on this information.

5. Many economists favor a low steady rate of inflation, low (as opposed to zero or
negative) inflation may reduce the severity of economic recessions by enabling the
labor market to adjust more quickly in a downturn, and reducing the risk that a
liquidity trap prevents monetary policy from stabilizing the economy. The task of
keeping the rate of inflation low and stable is usually given to monetary authorities.
Generally, these monetary authorities are the central banks that control the size of the
money supply through the setting of interest rates, through open market operations,
and through the setting of banking reserve requirements.
6. Tobin effect argues that: a moderate level of inflation can increase investment in an
economy leading to faster growth or at least higher steady state level of income. This
is due to the fact that inflation lowers the return on monetary assets relative to real
assets, such as physical capital. To avoid inflation, investors would switch from
holding their assets as money (or a similar, susceptible to inflation, form) to investing
in real capital projects.

The first three effects are only positive to a few elite, and therefore might not be considered
positive by the general public.

How to Survive Inflation?

Tips to avoid the negative effects of inflation are only suggestions and don’t constitute any
legal advice, therefore you’re free to use your own judgment depending on circumstances, to
be more prepared to face inflation effects you need to be aware of those effects, so if you
haven’t done so, please read some of them above, here are some tips:
1. Be wise when holding cash, whether in your home or in your savings account, if
you’re earning 5% interest on the money you have in your bank, and inflation rate is
10% then you’re in reality losing 5% and not earning anything.
2. Be careful when buying bonds, high inflation rates completely destroy the value of
long-term bonds.
3. If you have a variable-rate mortgage, fix it if you can find a good deal, have a low
fixed interest rate or 0% interest if you can find one.
4. Invest in durable goods or commodities rather than in money. Check out our
commodities list.
5. Invest in things that you're going to use anyway and will serve you for a long time.
6. Invest for long-term capital gains, because short term investments tend to give
deceptive results or sense of making profits while in reality you’re not making profits.
7. Learn about bartering which is trading goods or services without the exchange of
money (it was very popular in hyperinflation times).
8. Manage wisely your recurring monthly bills such as (phone bills, cable TV...), it
would help to reduce them or eliminate some of them.
 9. Same goes with ephemeral items (movies, restaurants, hotel rooms...) they’re not bad
if you spend money on them in moderation.
10.Ask yourself, do I really need these things I’m spending my money on? Think how
much and how often you will need something before buying it.
11.Use the money saving tips such as: you need to reduce your consumption of things
that are rising rapidly in price (eg, gas) without having to reduce your consumption of
goods that are rising less rapidly or even falling in price (eg, clothes).
12.Buy only what you need, especially objects that have multi-tasks, and are considered
durable goods.

The conclusion from all this is: You don’t have to live cheap, just live smart!

Difference between Monetary and Fiscal Policy

Fiscal policy and monetary policies are instruments utilized by governments to give impetus
to the economy of a nation and sometimes they are used to curb the excess growth. The
major differences between these two concepts are discussed below -

Subject Fiscal Policy Monetary Policy

1. Definitio It is fundamentally an attempt of
n the nation to give direction to the
economy through manipulation of
tax structures.
2. Nature Fiscal policy gives the direction of
economy of a nation.
3. Focus Fiscal policy relates to the
economic position of a nation.
Area Fiscal policy administers the
taxation structure of the nation
Scope Fiscal policy speaks of the
government economic program.
Responsibilit Fiscal Policy is carried out by the
y government
It is the procedure by which the
nation or its key bank influences
the supply of fund, rates of interest
and so on.
Monetary policy controls the
supply of money in the nation.
Monetary policy focuses on the
strategy of banks.
Monetary Policy helps to stabilize
the economy of the country.
Monetary policy sets the program
of key banks of the nation.
Monetary policy is usually carried
out by the Central Bank /
Monetary authorities

The main objectives of both the procedures are attainment of growth of economy and its
stability.
Instrument of Monetary Policy
Monetary policy guides the Central Bank’s supply of money in order to achieve the
objectives of price stability, full employment, and growth in aggregate income. The
instruments of monetary policy used by the Central Bank depend on the level of
development of the economy, especially its financial sector. The commonly used instruments
are discussed below –
Reserve Requirement: The Central Bank may require Deposit Money Banks to hold a
fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or deposits
with it. Fractional reserve limits the amount of loans banks can make to the domestic
economy and thus limit the supply of money. The assumption is that Deposit Money Banks
generally maintain a stable relationship between their reserve holdings and the amount of
credit they extend to the public.

Open Market Operations: The Central Bank buys or sells ((on behalf of the Fiscal
Authorities (the Treasury)) securities to the banking and non-banking public (that is in the
open market). One such security is Treasury Bills. When the Central Bank sells securities, it
reduces the supply of reserves and when it buys (back) securities-by redeeming them-it
increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of
money.

Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit
Money Banks, thus affecting the level of reserves and hence the monetary base.

Direct Credit Control: The Central Bank can direct Deposit Money Banks on the maximum
percentage or amount of loans (credit ceilings) to different economic sectors or activities,
interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way
the available savings is allocated and investment directed in particular directions.

Moral Suasion: The Central Bank issues licenses or operating permit to Deposit Money
Banks and also regulates the operation of the banking system. It can, from this advantage,
persuade banks to follow certain paths such as credit restraint or expansion, increased
savings mobilization and promotion of exports through financial support, which otherwise
they may not do, on the basis of their risk/return assessment.

Prudential Guidelines: The Central Bank may in writing require the Deposit Money Banks
to exercise particular care in their operations in order that specified outcomes are realized.
Key elements of prudential guidelines remove some discretion from bank management and
replace it with rules in decision making.

Exchange Rate: The balance of payments can be in deficit or in surplus and each of these
affect the monetary base, and hence the money supply in one direction or the other. By
selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at
levels that do not affect domestic money supply in undesired direction, through the balance
of payments and the real exchange rate. The real exchange rate when misaligned affects the
current account balance because of its impact on external competitiveness. Moral suasion
and prudential guidelines are direct supervision or qualitative instruments. The others are
quantitative instruments because they have numerical benchmarks.

Interest Rate: The Central Bank lends to financially sound Deposit Money Banks at a most
favorable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the
floor for the interest rate regime in the money market (the nominal anchor rate) and thereby
affects the supply of credit, the supply of savings (which affects the supply of reserves and
monetary aggregate) and the supply of investment (which affects full employment and
GDP).