Module 2: Theories of money and applications

Value of money
The value of money, for example the value of rupees note comprises the amount of
commodities and services that it helps to purchase.
Money purchases more when the prices of commodities and services are low and it purchases
less when prices are high.
The value of money, implying the purchasing power of money, depends on the level of prices.
The value of money cannot be found out directly but only indirectly, through the price level.
Definition
In the words of Crowther, “The value of money is what it will buy.” The amount of goods and
services received in exchange for a unit of money constitutes value of money. If in exchange
for one rupee one gets two pencils, then the value of the rupee will be two pencils.
According to Robertson, “By the value of money we mean the amount of the things in
general which will be given in exchange for a unit of money.” Value for money is based not
only on the minimum purchase price (economy) but also on the maximum efficiency and
effectiveness of the purchase.

Value of money and price level

The value of money is closely related to the prices of goods and services. As money is used
as a unit of account and as a measure of value of all other things, its own value can be
measured only through the prices of other things. The value of money therefore depends upon
the level of prices of goods and services to be purchased with money. The lower the price
level, the greater will be the purchasing power of money and the higher will be the value of
money; the higher the price level, the smaller will be the purchasing power of money and the
lower will be the value of money. Hence, there is inverse relationship between the value of
money (or the purchasing power of money) and the price level. The value of money is, thus,
the reciprocal of the price level.
Symbolically,
Vm=1/p

Where, Vm stands for the value of money, and

P stands for the price level.
Let us illustrate the relationship between value of money and price level with the help of an
example.
Price of salt is Rs. 10 per k.g. Here, a unit of money, i.e. one rupee can buy 100 grams of salt.
So, in this example value of money is 100 grams of salt. If the price falls to Rs. 8 per k.g., the
value of money will increase to 125 grams of salt because now one rupee can buy 125 grams
salt.

TYPES OF VALUE OF MONEY

The value of money is of two types
(i) The internal value of money and
(ii) The external value of money.
The internal value of money means the purchasing power of money over domestic goods and
services. The external value of money means the purchasing power of money over foreign
goods and services.

Fisher's Quantity Theory of Money

An American economist named Irving Fisher provided the version of the transaction of the
quantity theory of money in his book ‘The Purchasing Power of Money’ in the year 1911.
According to Fisher, as the quantity of money in circulation increases the other things remain
unchanged. The price level also increases in direct proportion as well as the value of money
decreases and vice-versa.
 (i) In Figure 1-A, when the money supply is doubled from OM to OM1, the price level is
also doubled from OP to OP1. When the money supply is halved from OM to OM2, the price
level is halved from OP to OP2. Price curve, P = f(M), is a 45° line showing a direct
proportional relationship between the money supply and the price level.

(ii) In Figure 1-B, when the money supply is doubled from OM to OM1; the value of money
is halved from O1/P to O1/P1 and when the money supply is halved from OM to OM2, the
value of money is doubled from O1/P to O1/P2. The value of money curve, 1/P = f (M) is a
rectangular hyperbola curve showing an inverse proportional relationship between the money
supply and the value of money.

Fisher's equation of exchange:

Fisher’s theory can be best explained with the help of a famous equation i.e.,

MV = PT
or
P = MV/T

Where;
M=Quantity of money
V= transaction velocity
P=price level
T= Total goods and service transacted
Like other commodities, the value of money or the price level is also determined by the
demand and supply of money.

MV (Supply of money)
Supply of money consists of a quantity of money in existence (M). It is multiplied by the
number of times this money changes hands which is the velocity of money (V). V is the
transaction velocity of the money in Fisher’s equation. That means that the average number
of times a unit of money turns over or changes hands to effectuate transactions during a
period.
Therefore, MV refers to the total volume of the money in circulation during a period. Since
the money is only to be used for transaction purposes; the total supply of money also forms
the total value of money expenditure in all the transactions in an economy during a period.

PT (Demand for Money)

Money is demanded not for its own sake (i.e., for hoarding it), but for transaction purposes.
The demand for money is equal to the total market value of all goods and services transacted.
It is obtained by multiplying total amount of things (T) by average price level (P).

Thus, Fisher’s equation of exchange represents equality between the supply of money or the
total value of money expenditures in all transactions and the demand for money or the total
value of all items transacted.

Supply of money = Demand for Money

Or
Total value of money expenditures in all transactions = Total value of all items transacted.
Or
MV = PT

The equation of exchange is an identity equation, i.e., MV is identically equal to PT (or MV =

PT). It means that in the ex-post or factual sense, the equation must always be true. The
equation states the fact that the actual total value of all money expenditures (MV) always
equals the actual total value of all items sold (PT).
What is spent for purchases (MV) and what is received for sale (PT) are always equal; what
someone spends must be received by someone. In this sense, the equation of exchange is not
a theory but rather a truism.

Assumptions of fisher's quantity theory of money:

1. Constant Velocity of Money:
According to Fisher, the velocity of money (V) is constant and is not influenced by the
changes in the quantity of money. The velocity of money depends upon exogenous factors
like population, trade activities, habits of the people, interest rate, etc. These factors are
relatively stable and change very slowly over time. Thus, V tends to remain constant so that
any change in supply of money (M) will have no effect on the velocity of money (V).
2. Constant Volume of Trade or Transactions:
Total volume of trade or transactions (T) is also assumed to be constant and is not affected by
changes in the quantity of money. T is viewed as independently determined by factors like
natural resources, technological development, population, etc., which are outside the equation
and change slowly over time. Thus, any change in the supply of money (M) will have no
effect on T. Constancy of T also means full employment of resources in the economy.
3. Price Level is a Passive Factor:
According to Fisher the price level (P) is a passive factor which means that the price level is
affected by other factors of equation, but it does not affect them. P is the effect and not the
cause in Fisher’s equation. An increase in M and V will raise the price level. Similarly, an
increase in T will reduce the price level.
4. Money is a Medium of Exchange:
The quantity theory of money assumed money only as a medium of exchange. Money
facilitates the transactions. It is not hoarded or held for speculative purposes.
5.Long Period:
The theory is based on the assumption of long period. Over a long period of time, V and T are
considered constant.

Conclusion
Quantity theory of money states that the quantity of money supplied in an economy is the
main determinants of price level and value of money because every increase or decrease in
the quantity of money there will be a proportionate increase or decrease in price level. And
this negatively effects value of money.

Criticism:
1.Unrealistic Assumption of Long Period
2. Neglects store value of money
3.MV is not always equal to PT
4.Velocity of money is not constant
5. Unrealistic assumptions of full employment
6. Ignores other determinants of price level
 CAMBRIDGE THEORY/ EQUATION

As an alternative to Fisher’s quantity theory of money, Marshall, Pigou, Robertson, Keynes,

etc. at the Cambridge University formulated the Cambridge cash-balance approach. Fisher’s
transactions approach emphasized the medium of exchange functions of money. On the other
hand, the Cambridge cash-balance approach was based on the store of value function of
money.
According to cash-balance approach, the demand for money and supply of money determines
the value of money. This approach, considers the demand for money and supply of money at
a particular moment of time. Since, at a particular moment the supply of money is fixed, it is
the demand for money which largely accounts for the changes in the price level. As such, the
cash-balance approach is also called the demand theory of money. The Cambridge cash-
balance approach considers the demand for money not as a medium of exchange but as a
store of value.
The actual demand for money comes from those who want to hold want to exchange it for
goods and services. Thus, according to Cambridge cash-balance approach, the demand for
money implies demand for cash balances. According to Cambridge cash-balance approach for
the given supply of money at a point of time, the value of money is determined by the
demand for cash balances. Cash balance is that proportion of the real income which the
people desire to hold in the form of money. When people increase their demand for money,
they will reduce their expenditures on goods and services in order to have larger cash
holdings. As a result demand for goods and services will fall. Fall in demand for goods and
services will reduce the price level and raise the value of money. Conversely, fall in the
demand for money will raise the price level and will reduce the value of money.
The Cambridge cash-balances equations of Marshal, Pigou, Robertson and Keynes are stated
as under:

Marshall’s Equation
The Marshallian cash-balance equation is expressed as follows:
MV = KPY
Where;
M is the supply of money (currency plus
demand deposits)
P is the price level
Y is aggregate real income; and
K is the fraction of the real income which the people desire to hold in the form of money.
The value of money (1/p) (or, the purchasing power of money), in terms of this equation, can
be found out by dividing the total quantity of goods which the people desire to hold out of the
total income (KY) by the total supply of money (M). Thus,
1/P=KY/M
Similarly, the price level (P) can be found out by dividing the total money supply (M) by the
quantity of goods which the people desire to hold out of the total income (KY). Thus,
P=M/KY
(i) The price level (P) is directly proportional to the money supply (M);
(ii) The price level (P) is indirectly proportional to the aggregate real income (Y) and the
proportion of the real income which people desire to keep in the form of money (K);
(iii) M and Y being constant, with the increase in K price level (P) falls and with the
decreases in K price level (P) rises;
(iv) K and Y remaining unchanged, if supply of money (M) increases, price level (P) rises
and if supply of money (M) decreases, price level (P) falls.

Pigou’s Equation
Pigou’s cash balance equation is as follows:
1/P=KR/M
Where
P is the price level and 1/p is the purchasing power;
R is the total real income or the real resources;
K is the proportion of real income held by the people in the form of money; and
M is the total money supply
Since money is held by the community in the form of cash and in the form of bank deposits,
According to Pigou, K was more significant than M in explaining changes in the purchasing
power of money (value of money). This means that the value of money depends upon the
demand of the people to hold money. Moreover, assuming K and R to be constant, the
relationship between money supply (M) and price level (P) is direct and proportional.

Robertson’s Equation:
Robertson’s cash balance equation is as follows:
M = KPT
Where,
P is the price level;
M is the money supply;
T is the total amount of goods and services to be purchased during a year.
K is the proportion of T which people wish to hold in the form cash.
According to Robertson’s cash balance equation, P changes directly with M and inversely
with K and T.

Keyne’s Equation:
Keyne’s cash balance equation is as follows:
n=pk
Or
p=n/k
Where
n is the cash held by the general public;
p is the price level of consumer goods;
k is the real balance or the proportion of consumer goods over which cash (n) is kept.
Assuming K to be constant, a change in ‘n’ causes a direct and proportional change in ‘p’. In
other words, if the quantity of money in circulation is doubled the price level will also be
doubled, provided k remains constant. In order to include bank deposits in money supply,
Criticism of cash-balance approach:
The cash-balance approach has been criticized on the following grounds:
(1) Like Fisher’s transaction equation, MV = PT, the Cambridge equation, M = KPY, is also a
simple truism.
(2) The cash-balance approach is based on the assumption that the demand for money has
uniform unitary elasticity. (This means that an increase in the desire for holding cash balance
(K) leads to equi-proportionate fall in the price level). This is an unrealistic assumption.
(3) The cash balance approach has not properly analyzed various motives for holding money.
For example, it ignored the speculative motive for holding money which causes violent
changes in the demand for money.
(4) A serious defect in the Cambridge equations (furnished by Pigou and Keynes) is that they
seek to explain the value of money (or, the purchasing power of money) in terms of
consumption goods only and ignored the investment goods altogether. Thus cash balance
approach has unduly narrowed down the conception of the purchasing power of money.
(5) The cash-balance approach ignored the role of rate of interest in explaining the changes in
the price level. The rate of interest has a definite influence on demand for money and, in turn,
on the price level.
(6) The approach ignored the influence of real factors like, income, saving, investment, etc.
on the price level.
(7) The cash balance approach ignored the real-balance effect which means that
(i) An individual’s wealth is influenced by the changes in money balances and the price level;
(ii) The changes in wealth further influence the expenditure on goods.
(8) The approach viewed the real income as the sole determinant of K. It has ignored the
influence of price level, banking and business habits of the people, business integration, etc.
on the value of K.
(9) The approach maintains that the value of money or the price level (P) is determined by K.
But it has been pointed out that K not only influences P but K is also influenced by P.
(10) In terms of cash balance approach it is difficult to visualize, the extent to which prices
and output will change as a result of a given change in the supply of money. Thus the
approach lacks quantitative analysis.
(11) Like Fisher’s Transactions approach, the Cambridge approach also assumes K and T as
given. But it is possible only in a static situation and not in dynamic situation.
(12) Like Fisher’s transactions approach, the Cambridge approach also provides no
explanation for trade cycle.

Friedman’s restatement of quantity theory of money

Friedman in his essay, " The Quantity Theory of Money - A Restatement published in 1956
beautifully restated the old quantity theory of money . In his restatement he says that " money
does matter ". For a better understanding and appreciation of Friedman's modern quantity
theory, it is necessary to state the major assumptions and beliefs of Friedman .

Assumptions:
* First of all Friedman says that his quantity theory is a theory of demand for money and not
a theory of output, income or prices.
* Secondly, Friedman distinguishes between two types of demand for money.
1) money is demanded for transaction purposes.
It serves as a medium of exchange. This view of money is the same as the old quantity
theory.
2) Money is demanded because it is considered as an asset.
Money is more basic than the medium of exchange. It is a temporary abode of purchasing
power and hence an asset or a part of wealth. Friedman treats the demand for money as a part
of the wealth theory.
* Thirdly, Friedman treats the demand for money just like the demand for any durable
consumer good.
The demand for money depends on three factors :
( a ) The total wealth to be held in various forms
( b ) The price or return from these various assets and
( c ) Tastes and preferences of the asset holders .

Friedman considers five different forms in which wealth can be held ,

1.money
Money includes cash in hand and deposit in bank . Money is taken in the broadest sense to
include currency , demand deposits and time deposits which yield interest on deposits . Thus
money is luxury good . It also yields real return in the form of convenience , security , etc. to
the holder which is measured in terms of the general price level ( P ) . when price level falls
value of money increase so return on money is high .
2.Bonds
Bonds are defined as claim to a time stream of payments that are fixed in nominal units or it
is a unit of corporate debt issued by companies and organisation . The return of bond is
effected by change in interest rate . The return on bond is represented as ' Rb '
3.Equities
Equities are defined as a claim to a time stream of payments that are fixed in real units or it is
share in a company. Return of equities affected by interest rate. The return on equities is
represented as “Re”
4.Physical non - human goods
Physical goods or non - human goods are inventories of producer and consumer durable. Like
land, house , and cars etc ... price of a goods over the period of time decide return on physical
goods . Return from physical non-human goods represented as " Rd "
5.Human capital
Human capital is the productive capacity of human beings. Thus each form of wealth has a
unique characteristic of its own and a different yield either explicitly in the form of interest,
dividends , labour income , etc. , human capital includes education health etc ..

Individual wealth divided between human wealth and non-human wealth. Ratio between
human wealth and non-human wealth is represented by "Y”
Total wealth includes all sources of income. Thus income (y) is one of the determinants of
demand for money.
Variable which effects taste and preference of wealth holder represented as " u “
Friedman in his latest empirical study Monetary Trends in the United States and the United
Kingdom (1982) gives the following demand function for money for an individual wealth
holder with slightly different notations from his original study of 1956 as:
Md =f (p, y, Rb , Re , Rd , w , u )
Where,
Md - demand for money
P - price level
y - real income
Rb- interest rate on bond
Re - return on equities
Rd - return on durable goods ( no- human goods )
w - ratio of nonhuman to human wealth
u - taste and preference of wealth holder

Friedman's quantity theory of money is explained in terms of Figure

Where income ( Y ) is measured on the vertical axis and the demand for the supply of money
are measured on the horizontal axis . MD is the demand for money curve which varies with
income .
MS is the money supply curve which is perfectly inelastic to changes in income . The two
curves intersect at E and determine the equilibrium income OY . If the money supply rises ,
the MS curve shifts to the right to M 1 S1 . As a result , the money supply is greater than the
demand for money which raises total expenditure until new equilibrium is established at E1 ,
between MD and M1S1 curves . The income rises to OY1.

Thus Friedman presents the quantity theory as the theory of the demand for money and the
demand for money is assumed to depend on asset prices or relative returns and wealth or
income . He shows how a theory of the stable demand for money becomes a theory of prices
and output . A discrepancy between the nominal quantity of money demanded and the
nominal quantity of money supplied will be evident primarily in attempted spending . As the
demand for money changes in response to changes in its determinants , it follows that
substantial changes in prices or nominal income are almost invariably the result of changes in
the nominal supply of money .
Conclusion :
Demand for money changes along with income
Its Criticisms :
1. Very Broad Definition of Money
2. Money not a Luxury Good
3. More Importance to Wealth Variables
4. Money Supply not Exogenous
5. Ignores the Effect of Other Variables on Money Supply
6. Does not consider Time Factor
7. No Positive Correlation between Money Supply and Money GNP

Index Numbers
Meaning :
The value of money does not remain constant over time . It rises or falls and is inversely
related to the changes in the price level . A rise in the price level means a fall in the value of
money and a fall in the price level means a rise in the value of money . Thus , changes in the
value of money are reflected by the changes in the general level of prices over a period of
time . Changes in the general level of prices can be measured by a statistical device known as
" index number”.
Index number is a technique of measuring changes in a variable or group of variables with
respect to time , geographical location or other characteristics . There can be various types of
index numbers , but , in the present context , we are concerned with price index numbers ,
which measures changes in the general price level ( or in the value of money ) over a period
of time .

Characteristics of index numbers

1. Index numbers are specialized averages
2. Index numbers are expressed in percentages
3. Index numbers measure changes not capable of direct measurement
4. Index numbers are comparative in nature .

Features of Index numbers :

The following are the main features of index numbers :

( i ) Index numbers are a special type of average . Whereas mean , median and mode measure
the absolute changes and are used to compare only those series which are expressed in the
same units , the technique of index numbers is used to measure the relative changes in the
level of a phenomenon where the measurement of absolute change is not possible and the
series are expressed in different types of items .

( ii ) Index numbers are meant to study the changes in the effects of such factors which
cannot be measured directly . For example , the general price level is an imaginary concept
and is not capable of direct measurement . But , through the technique of index numbers , it is
possible to have an idea of relative changes in the general level of prices by measuring
relative changes in the price level of different commodities .

( iii ) The technique of index numbers measures changes in one variable or group of related
variables . For example , one variable can be the price of wheat , and group of variables can
be the price of sugar , the price of milk and the price of rice .

( iv ) The technique of index numbers is used to compare the levels of a phenomenon on a

certain date with its level on some previous date ( e.g. , the price level in 1980 as compared to
that in 1960 taken as the base year ) or the levels of a phenomenon at different places on the
same date ( e.g. , the price level in India in 1980 in comparison with that in other countries in
1980 ) .

Types of Index Numbers

1. Simple Index Number :

A simple index number is a number that measures a relative change in a single
variable with respect to a base . These type of Index numbers are constructed from a
single item only .
2. Composite Index Number :
A composite index number is a number that measures an average relative changes in a
group of relative variables with respect to a base . A composite index number is built
from changes in a number of different items .
3. Price index Numbers :
Price index numbers measure the relative changes in prices of a commodity between
two periods . Prices can be either retail or wholesale . Price index numbers are useful
to comprehend and interpret varying economic and business conditions over time .
4. Quantity Index Numbers :
These types of index numbers are considered to measure changes in the physical
quantity of goods produced , consumed or sold of an item or a group of items .
5. Value Index Number :
A value index number is formed from the ratio of the aggregate value for a particular
period with that of the aggregate value that is found in the base period . The value
index is utilized for inventories , sales , and foreign trade , among others .

Uses of index numbers

1 . They measure the relative changes in variables .
2 . They reveal trends and tendencies
3. They helps Government in framing suitable policies
4 . easily comparable . They help in making comparisons by reducing the changes to
percentages which are
 5. They act as indicators of inflationary or deflationary tendencies . They act as a sort
of economic barometers , indicating the state of affairs in various sectors of economy .
6. Used to evaluate the purchasing power of money
7. Used for forecasting business and economic activities

Inflation
Meaning :
Inflation is commonly understood as a situation of substantial and rapid general increase in
the price level and consequent fall the value of money over a period of time . Inflation means
persistent rise in the general level of prices . Inflation is a long term operating dynamic
process . By and large , inflation is also a monetary phenomenon . It is usually characterized
by an overflow of money and credit . In fact , the root cause of inflation is the expansion of
money supply beyond the normal absorbing capacity of the economy . The behavior of
general prices is measured through price indices . The trend of price indices reveals the
course of inflation or deflation in the economy .
Inflation is often defined in terms of its supposed causes . Inflation exists when money
supply exceeds available goods and services .
Inflation may be defined as ' a sustained upward trend in the general level of prices ' and not
the price of only one or two goods .

Definition :
According to Crowther , " Inflation is a ' state ' is which the value of money is falling i.e. the
prices are rising . "
According to Milton Friedman . " Inflation is always and everywhere a monetary
phenomenon . " .
According to John Maynard Keynes . " Inflation is the result of the excess of aggregate
demand over the available aggregate supply and true inflation starts only after full
employment . "
According to Paul Samuelson . " Inflation occurs when the general level of prices and costs is
rising . "
According to Silverman , " Inflation is the name given to the expansion of the money
supplies whether in currency or credit in the excess of the amount justified by the government
for the trade .
" According to Arthur Cecil Pigou . " Inflation exists when income is expanding more than in
proportion to the income earning activities . " .
According to Hanson , " Inflation is present when the volume of purchasing power is
persistently running ahead of the output of goods and services so that there is a continuous
tendency for prices both for commodities and factors of production to rise because the supply
of goods and services and FPO's fail to keep pace with demand for them . "
• According to Ackely . " A persistent and appreciable rise in the general level or average of
prices . "
According to Meyer . " An increase in the prices that occurs after full employment has been
attained . " According to Coulbourn , " In inflation , too much money chases too few goods . "

Types of Inflation
1. Demand Pull Inflation
2. Cost – Push Inflation
3. Open Inflation
4. Repressed Inflation
5. Hyper - Inflation
6. Creeping and Moderate Inflation
7. True Inflation
8. Semi - Inflation
1.Demand Pull Inflation
This is when the aggregate demand in an economy exceeds the aggregate supply . This
increase in the aggregate demand might occur due to an increase in the money supply or
income or the level of public expenditure
2.Cost - Push Inflation
Supply can also cause inflationary pressure. If the aggregate demand remains unchanged but
the aggregate supply falls due to exogenous causes, then the price level increases.
3.Open Inflation This is the simplest form of inflation where the price level rises
continuously and is visible to people. You can see the annual rate of increase in the price
level.
4.Repressed Inflation Let's say that there is excess demand in an economy. Typically, this
leads to an increase in price . However, the Government can take some repressive measures
like price control, rationing, etc. to prevent the excess demand from increasing the prices .
5.Hyper - Inflation In hyperinflation, the price level increases at a rapid rate . In fact , you can
expect prices to increase every hour . Usually, this leads to the demonetization of an economy
6.Creeping and Moderate Inflation • Creeping - In this case , the price level increases very
slowly over an extended period of time . . Moderate - In this case, the rise in the price level is
neither too fast nor too slow - it is moderate .
7.True Inflation This takes place after the full employment of all the factor inputs of an
economy . When there is full employment , the national output becomes perfectly inelastic .
Therefore , more money simply implies higher prices and not more output .
8.Semi - Inflation Even before full employment , an economy might face inflationary
pressure due to bottlenecks from certain sectors of the economy .

Causes of Inflation :
 1. Growing Economy
In a growing or expanding economy , unemployment drops and wages usually rise . As a
result , more people find themselves with more money in their pocket , which they're
willing to spend on luxuries as well as necessities . This higher demand allows suppliers
to increase prices , which in turn leads to more jobs , which puts more money in
circulation , and round and round it goes .
In this context , inflation is considered a positive thing . Indeed , the Federal Reserve
wants there to be inflation , because it is a sign of a humming economy . But the Fed
wants only a little inflation , and aims for a 2 % annual core inflation rate . Many
economists agree , putting the target annual inflation rate at 2 % to 3 % as measured by
the consumer price index . They consider this a healthy increase as long as it doesn't
drastically outpace the growth of the economy as measured by gross domestic product
( GDP ) . Because a growing economy can lead to an increase in consumer spending and
demand , it is considered a form of demand - pull inflation .
2. Expansion of the Money Supply
An expanded money supply can also drive demand - pull inflation . This happens when
the Fed prints money at a rate higher than the growth rate of the economy . With more
money in circulation , demand grows and prices go up .
Here's another way to look at it : Think of an online auction . The more bidders ( or the
more money pursuing an object ) , the higher the price goes . Remember , money is
essentially worth whatever we believe is valuable enough to trade it for .
3. Government Regulation
The government can impose new laws or tariffs that make it more expensive for
companies to produce goods or import them . They pass on those higher expenses to
consumers in the form of increased prices . This results in cost - push inflation .
4. Managing the National Debt
When the national debt skyrockets , the government has two main options . One is to raise
taxes to make its debt payments . If it hikes corporate taxes , companies will likely shift
the burden onto consumers through higher prices . This is another scenario of cost - push
inflation .
The government's other option , of course , is to print more money . As explained earlier ,
this can result in demand - pull inflation . So if the government uses both approaches to
tackle the national debt , it may effect both demand - pull and cost - push inflation .
5. Exchange Rate Changes
When the value of the U.S. dollar dips in relation to foreign currency , it has less purchasing
power . In other words , imported products - the majority of consumer goods bought in
America - become more expensive to buy . Their cost goes up . The resulting inflation is
viewed as the cost - push kind .

Effects of inflation
Positive effects of Inflation :
The favourable impacts of inflation are as follows
1.Higher Profits
Inflation , usually , benefits the producers of products . They experience better profits since
they can sell their products at higher prices .
2.Better Investment Returns
During inflation, investors and entrepreneurs receive added incentives for investing in
productive activities . Therefore , they receive better returns .
3.Increase in Production
Once the producers receive the right investment , they create more goods and services .
Hence , inflation leads to an increase in production of products / services
4.More Employment and Better Income
Since production increases , there is an increased demand for the various factors of
production including manpower . Therefore , employment and income increases during
inflation
5.Shareholders can earn a good income
If a company earns higher profits , which is possible during inflation , it can declare
dividends to its shareholders . Thus , the shareholders can experience a rise in their dividend
income during inflationary periods .
6.Benefits to Borrowers
During inflation , the purchasing power of money decreases . Therefore , if the borrower is
paying a rate of interest which is less than the inflation rate , then he gains in the process .
This is because the real value of the money that the borrower returns is actually less than that
of the money borrowed .

Negative effects of Inflation :

The negative effects of inflation are as follows :
1.Fixed - Income Groups experience a fall in income
The true income of an individual is the purchasing power of his money income . In other
words,
Real Income = Money Income
__________________
Price Level
For people belonging to the fixed - income group like salaried individuals , pensioners , etc.
this means that they will experience a fall in real income . In other words , their purchasing
power will reduce .
2.Inequality in Income
Distribution Increases During inflation , businessmen and entrepreneurs experience an
increase in profits . On the other hand , people belonging to the fixed - income groups
experience a decline in their real income . Hence , the inequality in income distribution
becomes acute during this period .
3.Upsets the Planning Process
During inflation , the prices of goods , raw materials , and factor services increase . Therefore
, the Government has to spend more mon to complete any investment project taken up during
the planning period . If the Government fails to raise more financial resources through
savings or taxation , then it upsets the entire planning process .
4.Speculative Investment Increases
Let's say that the price levels are rising at a very fast rate . People are unsure about how much
the prices will rise in the next few weeks or months . In such cases , many people start
speculative investments .
For example , they might start purchasing shares , gems , land , etc. just for speculative
purposes . This is done with the objective of earning quick profits . Such investments do not
help in creating productive capital in the economy .
5.Harmful Effects on Capital Accumulation
Let's say that rising prices become chronic in an economy . During such periods , people start
preferring goods to money since the real value of money will fall in the future . Also , people
start preferring immediate consumption to consumption in the future .
Therefore , the general desire to save starts reducing . As the willingness and ability to save
reduces , the amount of funds available for further investment reduces too . Therefore , the
overall impact on the capital accumulation of the economy is negative since capital
accumulation in an economy depends on the growth of investment .
6.Lenders face Losses
Under favourable impacts of inflation , we mentioned that borrowers benefit from inflation .
Therefore , lenders stand a chance of losing during such periods . This is because they receive
an amount having lower purchasing power than the amount loaned .
7.Negative Impact on Export Income
Since the prices of raw materials and factors of production increase , the prices of export
items also increase during inflation . Hence , their demand in the foreign markets might fall
which leads to a fall in the export income of the country .

Remedial measures to control inflation

1. Monetary Measures
2. Fiscal Measures
3. Price Control
 1. Monetary Measures :
Monetary measures aim at reducing money incomes .
( a ) Credit Control :
One of the important monetary measures is monetary policy . The central bank of the country
adopts a number of methods to control the quantity and quality of credit . For this purpose , it
raises the bank rates , sells securities in the open market , raises the reserve ratio , and adopts
a number of selective credit control measures , such as raising margin requirements and
regulating consumer credit . Monetary policy may not be effective in controlling inflation , if
inflation is due to cost - push factors . Monetary policy can only be helpful in controlling
inflation due to demand - pull factors .
( b ) Demonetization of Currency :
However , one of the monetary measures is to demonetize currency of higher denominations .
Such a measures is usually adopted when there is abundance of black money in the country . (
c ) Issue of New Currency :
The most extreme monetary measure is the issue of new currency in place of the old
currency. Under this system , one new note is exchanged for a number of notes of the old
currency . The value of bank deposits is also fixed accordingly . Such a measure is adopted
when there is an excessive issue of notes and there is hyperinflation in the country . It is a
very effective measure. But is inequitable for its hurts the small depositors the most .
2. Fiscal Measures :
Monetary policy alone is incapable of controlling inflation . It should , therefore , be
supplemented by fiscal measures . Fiscal measures are highly effective for controlling
government expenditure , personal consumption expenditure , and private and public
investment .
The principal fiscal measures are the following :
( a ) Reduction in Unnecessary Expenditure :
The government should reduce unnecessary expenditure on non - development activities
in order to curb inflation . This will also put a check on private expenditure which is
dependent upon government demand for goods and services . But it is not easy to cut
government expenditure . Though this measure is always welcome but it becomes
difficult to distinguish between essential and non - essential expenditure . Therefore , this
measure should be supplemented by taxation .
( b ) Increase in Taxes :
To cut personal consumption expenditure , the rates of personal , corporate and
commodity taxes should be raised and even new taxes should be levied , but the rates of
taxes should not be so high as to discourage saving , investment and production . Rather ,
the tax system should provide larger incentives to those who save , invest and produce
more . Further , to bring more revenue into the tax - net , the government should penalise
the tax evaders by imposing heavy fines . Such measures are bound to be effective in
controlling inflation . To increase the supply of goods within the country , the government
should reduce import duties and increase export duties .
 ( c ) Increase in Savings :
Another measure is to increase savings on the part of the people . This will tend to reduce
disposable income with the people , and hence personal consumption expenditure . But
due to the rising cost of living , people are not in a position to save much voluntarily .
Keynes , therefore , advocated compulsory savings or what he called " deferred payment
where the saver gets his money back after some years . For this purpose , the government
should float public loans carrying high rates of interest , start saving schemes with prize
money , or lottery for long periods , etc. It should also introduce compulsory provident
fund , provident fund - cum - pension schemes , etc. All such measures increase savings
and are likely to be effective in controlling inflation .
( d ) Surplus Budgets :
An important measure is to adopt anti - inflationary budgetary policy . For this purpose ,
the government should give up deficit financing and instead have surplus budgets . It
means collecting more in revenues and spending less .
(e ) Public Debt
At the same time , it should stop repayment public dept and postpone it to till inflationary
pressures are controlled within the economy . Instead , the government she borrow more to
reduce money supply with the public.
3. Price Control :
Another method for ceasing inflation is preventing any further rise in the prices of
goods and services . In this method , inflation is suppressed by price control , but
cannot be controlled for the long term . In such a case , the basic inflationary pressure
in the economy is not exhibited in the form of rise in prices for a short time . Such
inflation is termed as suppressed inflation