Selected Q's in Money and Banking.

8/14/2019 Selected Q's in Money and Banking.

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Ahmed Ali Khan Page 1

Money and BankingSelected Questions and Answers.

Question 1. Why the needs of exchange were felt necessary?

Answer.

In olden days, when civilization started, human wants were limited.

Everyone used to produce whatever he/she needed. People were entirely

dependant on themselves for fulfilling their requirements. Hence, no need

for exchange was felt by them.

Gradually, the farming and fishing started, which increased the

requirements of the people. It was not possible for all of them to produce

everything for his needs. Then, specialization and division of labour began.Everyone began to produce those things with which he had know-how,

experience and advantage. Then they started exchanging their produce and

services with others. This created the need for exchange of goods and

services among the people.

Question 2. What is Barter economy? What are its shortcomings?

Answer.

In earlier days, when civilization started developing, peoples needsalso increased. They became specialized in producing one or few things, but

they were dependant on others products for complete satisfaction of their

wants. Thus, a barter economy was created among people to exchange goods

and services.

Therefore, Barter is the direct exchange of goods and services for

other goods and services. This system is called Barter economy.

Barter system requires two important conditions to be fulfilled:-

1. One must have desire to have a things produced by other.

2. He must be willing to give up a thing he produced in exchange for the

other thing which he desires.This is called double coincidence of wants.


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Short comings of Barter Economy are:

1. Lack of double coincidence of wants:

It is difficult to get a person who is ready to exchange a thing which is

required by others. A farmer desired fish in exchange of wheat but how

can he find a fisherman who needs wheat and is ready to exchange it for

his fish.

2. Lack of measurement of value.

Under Barter System, there is no standardized way to state the price of

commodities. All the things which were to be exchanged were not of the

same value, quality and quantity. It was therefore difficult to determine

the quantity of exchange between different goods. The quantity of

exchange of goods with other goods was generally dependant on the

intensity of wants of each individual at every time.

3. Lack of divisibility.

Suppose, a man requires a goat in exchange of chicken. How can he

divide the goat in exchange for two chickens?

4. Lack of store of value.

Barter system did not provide any method of storing generalized

purchasing power of goods. The value may decrease due to fiscal

deterioration or change of tastes.

5. Lack of easy transferability.

The transfer of wealth in shape of commodities is difficult to carry

from one place to another.

6. Difficulty of deferred payments.

Under Barter system, it was difficult to lend goods to other people

because the measure of value of goods may change due to lapse of time.

7. Difficulties in tax collection.Tax cannot be collected in the form of goods. Commodities not only

lose value as time passes, but are also difficult to store.

Question 3. What is Money? How is it defined in Pakistan?

Answer.


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Money is one of the wonderful inventions of man, but it has been

defined differently by different writers. Generally they defined money in

terms of its function. Some of the suitable definitions are given below:-

G.D.H Cole

Money is Something which buys things.

Marshall defines money as:

All the things which are any time and place, generally current without

doubt or special enquiry as a means of purchasing commodities and

services and of defraying of exchange.

R.P Kent. defines money as:

Money is anything which is commonly used and generally accepted as a

medium of exchange or a standard of value.

A. Walker defines money in these words:

Money is what money does.

Seligman says:

Money is the thing that possesses general acceptability.

Cassel defines money:

Any article that has the function of common measure for the valuation of

other goods is called money.

Crowther defined money:

Anything that is generally acceptable as a means of exchange and at the

same time acts as a measure and store of value.

In simple words, money can be defined as medium of exchange which

is generally acceptable as a price of goods and services and acceptable

for the settlement of debts. It is anything which is generally accepted in

exchange for other goods.

The main components of money supply are:

M1= Currency in circulation + Demand deposits with scheduled bank +

Other deposits with SBP. This can easily be used for the payment of any

debts.


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M2= M1+ Time deposits+ Resident foreign currency deposits. This can

be converted at a nominal rate to be used to settle the payment of debt.

M3= M2+ NDFC Bearer Certificates+ Deposits in NSSs +Deposit of

Federal Bank for Co-operatives. This includes the least liquid assets, and

to use this for settlement of payments after paying a significant sum as

penalty for conversion.

In Pakistan, Money is defined as M1 (narrow money), M2 (broader

definition used for monetary policy purposes) and M3 (used only in

Government and not by State Bank of Pakistan).

Question 4. Define the functions of money.

Answer.Money is the matter of function four:

A medium, a measure, a standard, a store.

Money has four basic functions:

1. Medium of Exchange.

2. Store of Value.

3. Unit of Account.

4. Standard of deferred payments.

1. Money as a Medium of Exchange:

Money as medium of exchange removes the problem of double

coincidence of wants of the barter economy. It is used to pay for goods

and services and is generally acceptable as a medium of exchange. It has

helped:

a) Promoting efficiency in the economy.

b) Reduced time spent in exchange of goods and services.

c) Increased specialization in various trades by reducing transaction cost

and encouraging division of labour.

2. Money as a Store of Value.

Money is portable, durable and stable in value. It can be easily

stored unlike surplus stock of commodities which is difficult to store due

to loss of its value over time.

3. Money as a Unit of Account.


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Another important function of money is that it provides a unit

of account. The monetary units of account are used to measure the value

of goods and services in the economy. It is a yardstick that allows the

measurement of the relative values of goods and services which reduce

transaction cost, time, efforts and expenses that was incurred in purchase

and sale of goods and services.

3. Money as a Standard of Deferred Payments.

This function of money simultaneously involves being a

medium of exchange and a unit of account. Debts are stated in monetary

units of account and are paid with a monetary medium of exchange. It is

used as a means of settlement of debt maturing in future. Money has

made borrowing and lending easy and less risky.

Question 5. What are the qualities of good money?

Answer.

The essential attributes are as follows:

1. General Acceptability

The essential quality of good money material is that it should be

acceptable in exchange for goods and services.

2. Stability of Value.

The money should be fairly stable in value.

3. Transportability.

The commodity chosen for money material should be light and

durable so that is easily transportable.

4. Storability.

The money material should be stored without depreciation in value.

5. Divisibility.Money should be divided easily in equal parts to allow for purchase

of smaller units or units of lesser value.

6. Homogeneity.

Money material should be of uniform quality and capable of

standardization.


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7. Cognizibility.

The perfect money is that it should be easily recognized.

8. Maleability.

The commodity selected as money should be capable of being molded

and stamped.

Question 6. Can credit cards, debit cards, and plastic card be regarded as

money?

Answer.

No. These cards are not units of account, a store of value and a

standard of deferred payment. In fact, these cards are a loan to customers

which are issued by the bank with a view to increase purchasing power.

Question 7. Write short notes on the following:

a) Fiat Money

b) Debasement

c) Seigniorage

d) Fiduciary Monetary Standard.

e) Full-bodied money

f) Representative full-bodied money.

Answer.

a) Fiat money

Money whose face value is more than its intrinsic value.

b) Debasement

A reduction in the quantity of precious metal in a metal coin that the

government issues as money.

c) Seigniorage

The process whereby the government gains profit by placing a face

value on a coin or other monetary token that exceeds its intrinsic value.

d) Fiduciary Monetary Standard.


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A monetary standard under which the currency is not backed by

anything except public confidence or faith that the currency is

exchangeable for goods and services.

e) Full-bodied money.

Money whose face value is equal to its intrinsic value.

a) Representative full-bodied money.

Money that is negligible value as a commodity, but is backed by

valuable commodity which can be converted into fixed nominal price.

Question 8. Multiple Choice Questions.

1) Money as a measure of value provides:

A) Its holder with perfect liquidity.

B) A common denominator for measuring value.

C) A mechanism for allocating resources.

D) A medium for exchanging final output.

2) In Pakistan, M1 money consists of:

A) Currency in circulation and demand deposit of saving bank and other

deposits with SBP.

B) Time deposits with scheduled banks.

C) NDFC Bearer Certificates and deposits of Co-operative banks.

3) Which of the following is not a true description of money:

A) It permits specialization in production.

B) It facilitates trade among regions.

C) It provides a standard of value.

D) It makes barter easy.

4) Money serves all but which of the following functions:

A) Medium of Exchange.

B) Hedge against Inflation.

C) Units of Account.

D) Store of Value


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5) Barter economy requires:

A) The use of Fiat Money.

B) The use of commodity money.

C) A double coincidence of wants.

D) Money to serve as a store of value.

6) Fiat Money:

A) Is backed by Gold.

B) Includes currency and gold stored in bank vaults.

C) Is the type of money that has no intrinsic value?

Answers:1 (B)

2 (A)

3 (D)

4 (B)

5 (C)

6 (C)

Q.9 True or false

1) Money and wealth is same thing.

2) Fiat money is money which is used in developing countries.

3) Credit card is good money and included in money supply.

4) Money has 3 functions: It acts as a medium of exchange, a unit

of account, and a hedge against inflation.

Answers:

1) False

2) False

3) False

4) False

Question 10

Describe briefly the various monetary systems?


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Answer.

In the primitive stages of economic development various commodities

like fish, cows, goat, and salt etc. were selected to be used as barter units of

value. They were replaced by uncoined metals which consequently taken

over by standardized coins. Today, paper money and bank deposits are the

major media of exchange

On the basis of evaluation according to the economic needs and

development, the money is generally classified under three main

heads:

1) Monometallism

2) Bymetallism

3) Paper money

1) Monometallism

When the value of monetary unit is fixed and maintained in terms of

one standard metal via gold or silver it is called monometallism.Under this system, the standard of money unit is gold. It is therefore

gold standard. If the unit of money is only silver it is called silver

standard.

2) Bimetallism

When the standard of metal are two, the system is called bimetallism

standard. In other words under bimetallism standard both gold and

silver are used as material for standard money and ratio of exchange is

fixed between their values.

3) Paper money

Under this system paper currency notes are issued by the central bank.

The value of paper money is maintained by placing restrictions on its

issues, It maybe convertible into gold/coin on demand. The law of the

country requires keeping compulsory reserve in form of gold or

approved foreign exchanges in order to issue the notes within

limitation.

Question 11.

Describe the advantages and disadvantages of paper money

AnswerThe paper money has number of advantages over metallic money

which are given as follows:

Advantages1) Economic precious metals:

Paper is cheaper than precious metals. Moreover cost of paper

printing currency is much less than the cost of minting the


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coins. Paper money has also saved the wear and tear of gold

and silver which was due to their constant use.

2) Elasticity

The quantity of money in circulation can be very easily

increased and decreased in accordance with the need of the

country. This system makes the monetary elastic and stable.

3) Easy portability

Paper currency notes are easily portable. Beside, its portability

it is safer, cheaper and more convenient.

4) Easy in Counting

It can be counted very easily in minimum time and accuracy

5) Easy to recognize

The paper money can be easily recognized.

6) Helpful to government

The government can increase its resources by printing of morenotes whenever required.

Disadvantages1) Unstable value

There is less stability of value in paper money as a result of

which its value fluctuates rapidly which changes the purchasing

power of money.

2) Danger of inflation

The developing countries adopt deficit financing through theissuing of paper currency which raises the price level and face

inflation.

3) Difficulties in foreign payment

The other countries are not bound to accept paper currency for

receipt and payment

4) Non durable

Paper currency can be easily mutilated, torn out and destroyed

and so loses its value.

Question 12What is gold standard? What are different forms of gold standard?

Answer

When the unit of money is exclusively defined by law as a

certain amount of gold of specified weight and fitness, this is called


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gold standard. The other form of money within the same monetary

system is kept at parity with amount of gold.

They are following distinct phases through which the gold

standard has passed:

1) Gold currency standard

2) Gold bullion standard

3) Gold exchange standard

4) Gold parity standard

1) Gold currency standard

When gold serves not only as a standard of value but also

circulate as coins, this is called full gold or gold currency

standard.

Main features of the full gold standard are as follows:

A) Free coinage in gold

B) Legal tender: Gold coins are declared as legal tendermoney.

C) Freedom of gold trade: there is no restriction in the trade

of gold

D) Convertibility: All other forms of currency e.g. none gold

coins, paper currency notes can be converted on demand

in to coins at fixed rate. People accept other forms of

currency because its value is equal to the gold coins. The

system could not be maintained after First World War

due to limited supply of gold.

2) Gold bullion standard

Under this system gold coins do not circulate. Actual currency

consisted of paper currency notes and token coins and these

were convertible at fixed rate into gold bars.

Main Features of the gold bullion standard are as follows:

A) Gold coins do not circulate. The actual currency consists

of paper currency notes and token coins which are

convertible into gold bullion.

B) Coinage of gold is not allowed

C) Gold reserve is kept at the central bankD) No restriction on use of gold. The public can have the

ability to obtain gold and use as well as for export.

3) Gold exchange standard

Under this system arrangement is made to purchase gold drafts

which are convertible in to gold abroad for the central bank.

Gold coins do not circulate within the country the local


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currency of notes and coins is converted into foreign exchange

based on gold.

Main features of the gold exchange standard

A) No circulation of gold coins.

B) Home currency is not convertible into gold

C) No Minting of Gold coins

D) Reserves in different forms of money: it is essential to

maintain in foreign countries a standard a reserve in gold

and a reserve in the local currency at home country to

provide resources for the maintenance of the exchange

value of currency

E) Stable exchange rates: The actual rates of exchange do

not vary widely from the fixed rate as gold drafts are sold

freely in both countries.

F) Economical. This system is very economical and theentire gold is saved form circulation.

4) Gold Parity standard

It is the lattice system. It prevails under the supervision of IMF.

No gold coins are put in circulation. Gold does not serve as a

medium of exchange. The currency of the country consists

largely of notes and coins and is not convertible into gold. But

the currency authorities are obliged to maintain the exchange

rate of the domestic currency stable in terms of a certain

quantity of gold. The members countries may suppose to have

gold parity standard.

Question 13

Bad money drives good money out of circulation Discuss.

Answer

There is a law which governs the circulation of money. In U.K

the queen was very much interested to reform the English

currency and was surprised to see that whatever new coins are

put into circulation, they disappeared. Sir Thomas Gresham wastherefore assigned to investigate into the matter. He explained

reasons of disappearance of new coins from circulation which is

known as Greshams law. He said whenever legal tender coins

of the same face value, But of different weights or degree of

fitness, are in current circulation, the light weight or loose coins

tend to drive the full weight pure coins out of circulation. This


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law in brief put on Bad money drives good money out of

circulation

The Bad money indicates old and worn out coins which have

lost of its value through long and constant use. Bad money also

means the depreciated money of a bimetallic standard currency.

Operation of the law

Greshams law operates in 3 ways:

A) Good money is horded

B) Good money is melted

C) Good money is exported

Good money means new full valued coins of standard weight

and fitness

The law operates in 3 situations:

A. When good money and bad money circulate side by

side.B. When metallic coins and depreciated paper money

circulate side by side.

C. When there are two standard, coins both unlimitedly

legal tender, both subject to free coinage and both

having metallic value equal to their face value.

Limitation of Law

The law is not applicable under the following circumstances:

A. Shortage of currency

B. Bad money is not disliked and accepted by the

public

C. Government action against hording, melting and

exporting of good money.

Question 14.

What to do you mean by value of money? How is it determined?

Answer

The value of money is variously used. Generally it may mean in the

following three ways:1) Weight and fitness of gold and silver. Value of money may

mean its command over a definite weight and fineness of

gold and silver as is the case under gold and silver standard

respectively.


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2) Value of money in foreign exchange. In case of foreign

exchange the value of money means, the value of home

currency in term of foreign currency.

3) Purchasing power of money. The next popular term used for

money means its purchasing power. The value of money is

the quantity of goods and services that is being purchased by

them for one unit of money.

The value of money or its purchasing power has an inverse

relation with the general level of prices. The high price of

things indicate low value of money and low prices of goods and

services means high value of money, in other words, a rise in

the value of money is a fall in the price and a fall in the value of

money means rise in general price level. High value of prices is

called appreciation and low value is known as depreciation.

How value of money is determined

The principal of demand and supply can be applied to the value

of money. In other words, like the value of any other

commodity, is determined by the demand for and supply of it.

Demand for money

The demand for money was well defined by Lord Keynes as the

amount of money that the people of the country wish to hold

either in the form of coins or currency notes or current deposits

in the bank. Money is demanded for the purpose of buying

goods and services. The more the goods and services are to be

bought and sold, the more is the demand for money. So the

demand for money depends on the total value of transactions of

goods and services. But the total production of supply and

goods in the country cannot be increased or decreased within a

short period of time. So the demand for money also remains the

same in a given period.

The supply of money:

The supply of money consists of metallic money whether full

bodied coins are token, currency notes, bank deposits and

certain deposits of central bank. The supply of money is used


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for buying and selling so it becomes clear that the value of

money is determined by the demand for and supply of money.

In other words the demand for money remaining the same the

value of money is determined by the supply of money or

quantity of money in circulation.

Question 15

Critically examine the Fishers quantity theory of money.

Answer

Ervin Fisher, an American economist put forward the Cash

Transaction Approach to the quantity theory of money. He has stated

that the value of money in a given period of time depends upon the

quantity of money in circulation in the economy. It is the quantity of

money which determines the general price level and the value ofmoney. Any change in the money supply directly affects the general

price level and the value of money inversely in the same proportion.

In Fishers words Other things remaining unchanged, as the quantity

of money in circulation increases, the price level also increases in

direct proportion and the value of money decreases and vice versa

for example if the quantity of money in circulation is doubled then

other things being equal the general price will be doubled and the

value of money halved. Similarly if the quantity if money is halved,

the price level will be halved, and the value of money will be doubled.

In Fishers cash transaction version money the general price level in a

country, like the prices of commodities, it is determined by the supply

of and demand for money

A) Supply of money: The supply of money consists of the quantity of

money in circulation (M) and the velocity of its circulation (V) i.e. the

number of times the money changes hands. Thus MV refers to the total

value of money in circulation during a given period of time. For example if

the total money supply in Pakistan Rs. 5,000 billion and its velocity per unit

of time is 10 times, then the money supply could be Rs.5000 10 =Rs.50,000 billion

Demand for money

People demand money not for its own sake. They demand money

because it serves as a medium of exchange. It is used to carry


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everyday transactions. In short the demand for money is for the

exchange of money

Equation of exchange

The cash transaction version of the quantity theory of money was

presented by Irving Fisher in the form of an equation:

P = MV + M1V1 or PT = MV + M1V

T

Here, P is the price level

M is the quantity of money

V is the velocity of circulation of M

M1 is the of credit money

V1 is the velocity of circulation of M1

T is the total volume of goods and Trade

Explanation:

The Irving Fishers quantity theory of money can be explained by taking an

example. Let us suppose

M=Rs.2000,

M1= Rs.1000,

V=6,

V1=4,

T=8000 goods.

P=MV+M1V1

T

P= (2000 x 6) + (1000 x 4) = 12000 + 4000

8000 8000

= 16000 = Rs.2 per good.

8000

If the supply of money is doubled then:

P= (4000 x 6) + (2000 x 4) = 24000+8000

8000 8000


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=Rs. 4 per good.

Thus when the money supply is doubled, the price level is doubled.

i.e., the price of the good rises from Rs.2 to Rs.4 per unit and the value of

money is halved= Rs.2

The direct and proportionate relationship between the supply of

money and the general price level is explained with the help of the following

figure:

Figure A)


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Figure B)

In figure A) it is shown that when the supply of money is increased form

QM to QM2, the price level also increases from OP1 to OP2 . As the quality of

money increases four times to QM4, the price level also increases to OP4.

In figure B) the inverse relationship between quantity of money in

circulation and the value of money is shown. When the quantity is QM1 to

QM2, the value of money is reduced to half from VM1 to VM2.

Assumption of the theory

1) Full employment. The theory is based on the assumption of full

employment in the economy

2) T and V are constant. The theory assumes that value of trade (T) inthe short run remains constant. So is the case with velocity of money

(B) which remains unaffected.

3) Constant relation between M and M1. Fisher assumes constant

relation between currency money and credit money M1


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4) Price level (P) is pacificator. The price level (P) is inactive or

passive in equation. P is affected by other factors in equation i.e. T,

M, M1, V, and V1but P does not affect them.

Criticism of the theory

The quantity theory is subjected to the following criticisms:

1) Unrealistic assumptions. The theory is based on

unrealistic assumptions. In this theory P is considered as a

passive factor. T is independent. M1, V, V1 are constant in the

short run. All these assumptions are covered under other things

remaining the same. In actual working of the economy, these do

not remain constant. Hence, the theory is unrealistic and

misleading.

2) Various variables in the transaction are not

independent. The various variables in transaction equation are

not independent as assumed in theory. The fact is that they very

much influence each other for example when money supplied

(M) increases the velocity of money (V) also goes up. Take an

other case Fisher assumes (P) is a paccifactor and has no effect

on trade (T) in actual practice when price level (P) rises; it

increases profits and promotes trade (T).

3) Assumption of full employment is wrong. J.M. Keynes

has raised an objection that the assumption of full employment is

a rare phenomenon in the economy and the theory is not real.

4) Rate of interest ignored. In the quantity theory of Fisher

the influence of the rate of interest on the money supply and the

level of prices has been completely ignored

5) Fails to explain trade cycles. The theory fails to explain

the trade cycles it does not tell as to why during depression, theincrease in money supply has little impact on the price level.

Similarly, in boom period the reduction in money supply or tight

money policy may not bring down the price level. G. Crowther is

right in saying the quantity is at best an imperfect guide to the

cause of the business cycle.


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6) Ignores other factors of price level. There are many

determinants other than M, V, and T. Which have important

implications on the price level? These factors such as income,

expenditure, saving, investment, population, consumption, etc.

had been ignored from the purview of this theory.

Question 16

What is quantity theory of money? What are different approaches of

theory and how they differ from each other?

Answer

It is the theory that nominal income is determined solely by

movement in the quantity of money leading to the equation of

exchange Ms V = PT with V constant.

a) Irving Fishers Quantity theory of money suggests that thedemand for money is purely a function of income, and interest

rates have no effect on the demand for money. It also assumes that

economy will always tend to full employment, national income and

the stability of velocity arises from the technological and

institutional framework.

b) Cambridge Cash Balance Approach did not rule out the

effect of interest rate on demand for money assuming that money

function as a medium of exchange that people can use to carry out

transactions which depends on the level of transactions or nominal

income, and money also functions as a store of wealth. This

depends on individual choice and does not rule out effect of

interest rates.

c) Milton Friedman Quantity theory of money suggest that

demand for real balances is determined by wealth or permanent

income, interest rates on different instruments for holding money

and expected inflation.

Multiple choices.

1. The value of money primarily depends on

A) The amount that backs the money

B) Whether the bulk of it is paper or metallic

C) Its purchasing power

D) Who issues it

2. The amount of money held for transaction balances will


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A) vary positively with the value of national income

B) vary positively with interest rates

C) very negatively with the value of national income

D) Be larger with shorter interval between paydays.

Answers 1. c) 2. a)

Question 17

Define Inflation? What are the causes of Inflation? How can it be

controlled?

Answer.

Inflation is a process in which the price level is rising at a rapid rate

and money is losing its value. In the words of Gardner Ackley, Inflation

may be defined as persistent and appreciable rise in the general level oraverage of prices. Kent defined inflation as Inflation is nothing more than a

sharp upward movement in the price level. Keynes says inflation is Any

rise in the price level, after the level of full employment has been achieved.

So it can be concluded that Inflation is a persistent rise in prices rather than a

sudden rise in prices.

It may be noted that rising general level of prices does not mean that

all prices are necessarily rising. Even during inflation, the prices of some

goods may remain relatively constant and a few other actually falling.

Therefore, Inflation is a continued upward movement in the general

(average) level of prices. In the words of Milton Friedman, By inflation is

meant a steady and sustained rise in the prices.

Causes of Inflation.

The causes of inflation are generally grouped under two main

headings:

(A) Demand-pull inflation.

(B) Cost-push inflation.

A. Demand-Pull InflationDemand-pull inflation occurs when aggregate demand for goods

exceeds aggregate supply of goods at current prices, thus leading to an

increase in the price level. The factors which bring about an increase in

aggregate demand for goods or rise in the general level of prices are grouped

under two separate headings: (1) factors operating on the demand side, (2)

factors operating on the supply side.


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(1) Factors operating on the demand-side which bring continuous rise in the

general price level:

Increase in Money Supply.An increase in money supply leads to an increase in money

income. The increase in money income raises the aggregate demand for

goods and services. The supply of money increases when the government

resorts to deficit financing or commercial banks expand credit. When too

much money chases too few goods the result is an increase in general

price level.

Increase in Government Expenditure.

If there is an increase in government expenditure due to

adoption of development and welfare activities or the country has to fighta war, it causes an increase in government expenditure which leads to

increase in aggregate demand for goods and services and hence the price

level goes up.

Increase in Private Expenditure.

A continuous increase in consumption and investment

expenditure in the private sector raises the demand for goods and services

and leads to inflationary rise in prices.

Increase in Population.

The rapidly rising population exerts pressure on the demand of

goods and services. If the supply of goods and services fail to match with

the demand, the general price level moves upward.

Black Money

The money generated through smuggling and tax-evasion raises

the demand for luxury and other goods. Hence it is one of the causes for

raising the aggregate demand for goods and a rise in the general price

level.

(2) Factors operating on the supply-side which cause decrease in the

supply of goods:


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If the increase in aggregate demand for goods and services is matched by

an increase in the supply of goods, it will not cause inflationary situation.

When the aggregate supply of goods is at a slower pace than the growth

in aggregate demand, it then causes inflationary rise in the prices. The

following factors are identified for relatively slower growth in the supply

of goods:

Lagging agricultural and industrial production.

The increase in population, income, employment and

urbanization exerts pressure on the demand for goods and services.

However, the agriculture and industrial production and growth is at a

slower pace due to shortage of essential inputs like fertilizers, water,

cement, iron etc. When aggregate demand for goods and services exceeds

the aggregate supply of it, it causes a rise in prices of agriculture and

industrial goods.

Inadequate infrastructure facilities.

If in a country, there is a shortage of power, transport and

communication facilities due to inefficiency, it results in the slowing

down of overall production of goods. When the supply of such goods

falls short of demand, the prices go up.

Long gestation period.

If the time lag between investment and production of goods islong, a shortage of goods will arise. This will also contribute to

inflationary pressures.

B. Cost-push Inflation.

Cost-push inflation occurs when there is an increase in the cost of

production of goods and is not associated with excess demand. The main

causes of cost-push inflation are:

Increase in money wage rates.

The wage-push inflation occurs when strong labour unions

manage to press for wage increase in excess of labour productivity. Unit

cost of production is therefore raised. The rise in cost of production

exerts pressure on sellers to increase price of goods so as to get profit

margin.


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Profit-push inflation.

If the producers of certain commodities have monopoly over or

near monopoly power in the market, they fix up higher profit margin. The

higher profit margin thus inflates the price level.

Material-push inflation.

If there is an increase in the prices of some basic materials such

as gas, steel, chemicals, oil etc, which are used directly or indirectly in

almost all industries, it causes an increase in the cost of production and

hence, in the general price level.

Higher taxes.

If the government levies new taxes and raises the rate of old

taxes, the producers generally shift the burden of the taxes onto the

consumer. The increase in the selling price of the commodity pushes upthe inflationary trend in the economy.

Import goods.

If the price of the imported goods increases, it also results in the

contribution of inflation.

Remedies of Inflation.

The main measures which are used to control inflation are: 1) monetarypolicy, 2) fiscal policy and other measures.

1) Monetary Policy.

Monetary policy is a policy that influences the economy through changes

in the money supply and available credits. Monetary policy is adopted by

central bank of the country. Their measures to control inflation are a)

quantitative control and b) qualitative control. This includes open market

operations, variation in bank rates, credit rationing, varying reserve

requirements, varying margin requirements and consumer credit

regulations.

2) Fiscal Policy.

Fiscal policy is the deliberate change in either government spending or

taxes to stimulate or slow down the economy. It is the budgetary policy

of the government relating to taxes, public expenditure, public borrowing


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and deficit financing. Fiscal policy is based upon demand management,

i.e., raising or lowering the level of aggregate demand by controlling

various expenditures, government expenditures, consumption

expenditures and investment expenditure.

2) Other measures.

Other measures which are helpful in controlling inflation are

a) Price report program.

b) Provision of subsidies.

c) Arrangement of easy availability of goods on hire-purchase.

d) Imposing direct control on price of essential items.

e) Rationing of essential consumer goods.

Question 18.

Write short notes:Deflation

Reflation

Stagflation

Disinflation.

Answer

1) Deflation is just the opposite of inflation. If the general level of prices

falls and as a result thereof the value of money increases, it is called

Deflation. In the words of Crowther Deflation is that state of

economy where the value of money is rising or prices are falling.

Deflation refers to a sustained decrease in the general price level.

Deflation thus refers to a situation where prices fall causing major

increase in unemployment, reduction in output, and decrease in

income.

2) Reflation is a situation of moderately rising general prices when

efforts are made by the government to lift the economy out of

depression. The upward rise in general prices is characterized byexpending production, rising consumer expenditure, replacement of

old machinery and increasing profit. In the words of G.D Cole

Reflation may be defined as inflation deliberately undertaken to

relieve a depression. In reflation the rising prices are accompanied by

a rise in output and employment.


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3) Stagflation: the advance countries of the world since 1960 are facing

twin problems of rising prices and unemployment. The term

stagflation was coined to explain the co-existence of inflation and

employment. In the words of Samuelson Stagflation involves

inflationary rise in prices and wages at the same time. The people are

unable to find jobs and firms are unable to find customers for what

their plants can produce. In the words of Michael Swan Stagflation

can be described as a contraction or stagnation of a nations output

accompanied by rise in the price level.

4) Disinflation: The term Disinflation is becoming very popular with the

modern economists. In capitalistic countries of the world, there is a

tendency of the general prices to go up. People are losing faith in the

ability of money to keep its value. It is the desire of every government

that the prices should remain at reasonable level. The process orprocesses through which prices are brought down without causing

unemployment and reducing output is called Disinflation.

Question 19

Multiple Choice Questions.

1) Inflation is a situation in which:

A) There is a decrease in the purchasing power of the monetary unit.

B) There is a rise in the price level.

C) A given quantity of money purchases a large quantity of goods.

D) Increases in the price level exceed increase in the nominal wage.

2) Cost-push inflation exists when:

A) Consumers use their market power to push up prices.

B) Resource owners use their market power to push up prices.

C) Potential output is growing faster than real GDP.

D) Real GDP is increasing faster than potential GDP.

3) Un-anticipated inflation is harmful to:A) Retired persons whose income is fixed.

B) Debtors

C) Creditors

D) Economic growth but has no effect upon individual members of the

economy.


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4) Inflation is hardest on:

A) Persons who borrow money to be repaid in future.

B) Person who hold basic commodities

C) Fixed income groups and retired persons.

D) Workers whose costs of living clauses in wage contracts.

5) Which of the following must be a consequence of inflation?

A) Interest rate will rise

B) Exchange rate will go up.

C) The value of money will fall.

D) Unemployment will increase.

6) Which one of the following is likely to cause demand-pull inflation?

A) A fall in the exchange rate.

B) Increase in the wage rates.C) An increase in the value added tax.

D) An increase in oil prices.

E) An attempt by government to spend greater than its revenue.

7) The attempt by the government to reduce the level of economic

activity during a period of excess demand is known as:

A) Inflation

B) Deflation

C) Reflation

D) Recession

E) Expansion.

8) Which of the following policy action is most appropriate for reducing

inflation?

A) Central Bank purchases government securities.

B) An increase in the required reserves.

C) Easy money to hold down interest rates.

D) Encouragement of banks to borrow from Central Bank.

E) An increase in the growth rate of Money Supply.

Answers:

1 (A) 2 (B) 3 (C) 4 (C) 5 (C) 6 (E) 7 (B) 8 (B)

Selected Q's in Money and Banking.

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