economics 2nd year class 12 notes chapter 1 to chapter 17. chapter 4 value of money fa fsc notes.
Value of Money Chapter 4 Class 12 notes
Table of Contents
Q.1) What is meant by the ‘rise’ and ‘fall’ in the value of money? How can the changes in the value of money be measured?
Answer:
Rise and fall in the value of money mean increase or decrease in the value of money. When we say that the value of money is falling, it means that a unit of money can buy fewer goods and services. Value of money has an inverse relation with the general price level. A rose in the general price level would thus indicate a fall in the value of money and vice versa.
Value = 1/p
Where p = general price level
The changes in the general price level are measured by constructing index numbers.
In Pakistan, prices are rising every year, so the value of money is falling. A rupee in 2008 is worth about one paisa in 1960.
Since money acts as a measuring rod of value for all other goods and services, it is
essential that we should know how the value of money itself is determined. What are the factors, which bring about changes in the general price level or, what is the same thing, the purchasing power of money? There are various theories to explain how the value of money is determined. One of those is the quantity theory of money.
Measurement of changes in price
Changes in price are not uniform, some rise , some fall and others remain constant but there may be a trend in a particular direction. A comparison of price changes would give a very confusing picture. so for that value of money is also brought to concern to be particular.
Index number
This is a tool to measure the changes in the value of money or price level, which are closely linked. index number is a tabular representation of these changes in a very particular way.
Q.2) a. Explain the ‘Equation of Exchange.’
b) Find ‘V’ and the nominal value of GNP when money supply is Rs.250, average price of output is Rs. 4 and ’Q’ equals 400
Answer:
A) Equation of Exchange
Prof. Irving Fisher expressed the quantity theory of money in a simple equation, which is called Equation of Exchange. It is as:
P = MV/T or PT = MV
here
P = general price level
M = quantity of money or stock of money/
V = velocity of circulation of money
T = volume of transactions i.e. number of goods bought and sold using money
In this formula PT represents demand of money while MV gives supply of money. Demand for money equals supply of money. Fisher assumes that in a short period T and V remain constant; therefore, P will change directly with M.
Example
Suppose the initial position in this economy is as:
M = 100 (million rupees)
V = 5
T = 50 (millions)
P = MV/T
P1 = 100 x 5/50 = 500/50 = 10
Now, let M be doubled, velocity (V) and quantity of goods remain the same.
P2 = 200 x 5/ 50 = 20
Thus we see that when M is doubled, price level is doubled which means that value of
money has fallen to one half.
Assumptions
The quantity theory is based on some assumptions:
- 1. The theory applies to the changes in prices only in a short period.
- 2. There is full employment in the economy.
- 3. The velocity of money and production of goods remain constant.
- 4. The amount of barter trade remains constant.
- 5. M, V and T change independently.
6. All the stock of money is meant for purchasing of goods or services and not for hoarding or storing.
B) Solution:
S = 250
A = 4
Q = 400
V =?
P = MV/T
PT = MV
400 * 4 = 250 V
V = 1600/250
V= 6.4
Q.3) What is the value of money? What are the effects of changes in the value of money?
Answer:
Value of Money
Value of money means purchasing power of money. When we say that the value of money is falling, it means that a unit of money can buy fewer goods and services. Value of money has an inverse relation with the general price level. A rose in general price level would thus indicate a fall in the value of money and vice versa.
Value = 1/p
Where p = general price level
The changes in the general price level are measured by constructing index numbers.
In Pakistan, prices are rising every year, so the value of money is falling. A rupee in 2008 is worth about one paisa in 1960.
Since money acts as a measuring rod of value for all other goods and services, it is essential that we should know how the value of money itself is determined. What are the factors, which bring about changes in the general price level or, what is the same thing, purchasing power of money? There are various theories to explain how value of money is determined. One of those is the quantity theory of money.
Effects of Changes in Prices
Effect of change in the general price level is not the same for all. Some sections of society benefit while the others suffer.
1. Fixed Income Groups
Rising prices hurt fixed-income groups of people. The persons getting income from rent, interest and salaries, have fixed incomes. When prices rise, the purchasing power of their fixed income falls. On the other hand if prices fall they gain.
2. Business Community
The businessmen and industrialists gain from rising prices. Since their costs of rent, wages and interest remain fixed, while the prices of output rise, profits increase. When prices are falling, the business community suffers due to shrinking of their profits.
3. Consumers
Rise in prices has an adverse effect on consumers. Their real income falls and they can buy less amount of goods with their incomes. When prices fall their capacity to buy goods with the given amount of money increases.
4. Working Classes
Working classes suffer during rising prices. Their wages do not rise at the rate prices do. So their real wages fall. During falling prices such people gain.
5. Farmers
Farmers are happy during rising prices. The prices of farm products rise faster relative to industrial products.
6. Debtors and Creditors
If price rises, debtors gain while creditors lose. The debtors find it easier to pay off their debts, because of the rise in their incomes. The creditors get money and now have low purchasing power.
7. Investment and Employment
Since rising prices increase profits, investment is encouraged, which in turn creates more employment opportunities. Fall in prices has an adverse effect on investment activity and employment level.
8. Production
Rising prices have a positive effect on production of goods and services. This happens because of inducement of high profits.
9. Distribution of wealth
Inflation increases inequality in distribution of wealth and incomes. The rich class mostly consists of big landlords, businessmen etc. rising prices bring higher incomes for this group. The wages of poor people working classes do not rise.
10. National Income
Although the rising prices harm many sections of the community, yet, as far as the collective interest of the people is concerned, slowly rising prices are better than falling prices because production and employment level rise.
11. Savers
They are adversely affected by rising prices. Those who save and keep the amount as cash or in current accounts are losers when the trend of prices is upward.
If we consider all the plus and minus points of rising prices, we find that slowly rising prices are in the interest of the country. It will have a good effect on employment, investment, production, national income etc. but if prices start rising too fast, the economy will be badly affected. Falling of prices, in general, is not desirable. This is the lesson which governments and economists learnt after the Great Depression of 1930’s. so the governments do not let prices fall.
Q.4) Value of money has an inverse relationship with the quantity of money? Discuss.
Answer:
Inverse relationship of value of money with quantity of money.
According to the Quantity theory of money, the value of money is inversely related to the quantity of money in circulation. Any change in the total quantity of money in the country affects prices, and the change in the prices of goods affects the value of money. In simple words, quantity theory of money states that changes in general price level occur due to changes in quantity of money in circulation, so that an increase in the quantity of money causes a rise in the price level and fall in value of money.
“Other things remain constant, the general level of prices in an economy moves in direct proportion to the changes in the supply of money”.
Taussig defines the theory as:
“Double the quantity of money and other things being equal, prices will be twice as high as before, and the value of money one half. Half the quantity of money and other things being equal, prices will be one half of what they were before and the value of money double”.
Thus we see that according to the above given definition, the changes in quantity of money affects the price level in direct proportion. And since value of money and price level have an inverse relation with each other, we can say that quantity of money and value of money are inversely proportional.
Equation of Exchange
Prof. Irving Fisher expressed the quantity theory of money in a simple equation, which is called Equation of Exchange. It is as:
P = MV/T or PT = MV
Where
P = general price level
M = quantity of money or stock of money
V = velocity of circulation of money
T = volume of transactions i.e. number of goods bought and sold using money
In this formula PT represents demand of money while MV gives supply of money. Demand for money equals supply of money. Fisher assumes that in a short period T and V remain constant; therefore, P will change directly with M.
Example
Suppose the initial position in this economy is as:
M = 100 (million rupees)
V = 5
T = 50 (millions)
P = MV/T
P1 = 100 x 5/50 = 500/50 = 10
Now, let M be doubled, velocity (V) and quantity of goods remain the same.
P2 = 200 x 5/ 50 = 20
Thus we see that when M is doubled, price level is doubled which means that value of money has fallen to one half.
Assumptions
The quantity theory is based on some assumptions:
1. The theory applies to the changes in prices only in a short period.
2. There is full employment in the economy.
3. The velocity of money and production of goods remain constant.
4. The amount of barter trade remains constant.
5. M, V and T change independently.
6. All the stock of money is meant for purchasing of goods or services and not for hoarding or storing.
Q.5) Examine the quantity theory of money . Give its criticism
Answer:
Quantity Theory of Money
According to this theory, the value of money is inversely related to the quantity of money in circulation. Any change in the total quantity of money in the country affects prices, and the change in the prices of goods affects the value of money. In simple words, quantity theory of money states that changes in general price level occur due to changes in quantity of money in circulation, so that an increase in the quantity of money causes a rise in the price level and fall in value of money.
“Other things remain constant, the general level of prices in an economy moves in direct proportion to the changes in the supply of money”.
Taussig defines the theory as:
“Double the quantity of money and other things being equal, prices will be twice as high as before, and the value of money one half. Half the quantity of money and other things being equal, prices will be one half of what they were before and the value of money double”.
Thus we see that according to the above-given definition, the changes in quantity of money affects the price level in direct proportion. And since the value of money and price level have an inverse relationship with each other, we can say that quantity of money and value of money are inversely proportional.
Equation of Exchange
Prof. Irving Fisher expressed the quantity theory of money in a simple equation, which is called the Equation of Exchange. It is as:
P = MV/T or PT = MV
Where
P = general price level
M = quantity of money or stock of money
V = velocity of circulation of money
T = volume of transactions i.e. the number of goods bought and sold using money
In this formula, PT represents the demand for money while MV gives a supply of money. Demand for money equals the supply of money. Fisher assumes that in a short period T and V remain constant; therefore, P will change directly with M.
Example
Suppose the initial position in this economy is as:
M = 100 (million rupees)
V = 5
T = 50 (millions)
P = MV/T
P1 = 100 x 5/50 = 500/50 = 10
Now, let M be doubled, velocity (V) and the quantity of goods remain the same.
P2 = 200 x 5/ 50 = 20
Thus we see that when M is doubled, the price level is doubled which means that the value of money has fallen to one half.
Assumptions
The quantity theory is based on some assumptions:
1. The theory applies to the changes in prices only in a short period.
2. There is full employment in the economy.
3. The velocity of money and production of goods remain constant.
4. The amount of barter trade remains constant.
5. M, V and T change independently.
6. All the stock of money is meant for purchasing of goods or services and not for hoarding or storing.
Criticism
This theory has been strongly criticized on many grounds. It is based on wrong assumptions. In practice, the relation of quantity and value of money is not definite
1. “Other things” do not remain constant in practice. The variables V and T change even in a short time. Thus prices may not rise because T has increased along with a supply of money (M).
2. M, V or T etc. do not change independently. If one changes, it affects the other variables (e.g. if as a result of an increase in M and price level starts rising, then both production of goods and the velocity of money will be affected).
3. Change in price level may not be proportional to the change in the quantity of money e.g. a 50% change in the money supply may change P more or less than 50%. This theory only explains the tendency of the price level and not exact change.
4. The theory lays more stress on the effect of the supply of money on prices. It ignores the effect of demand for money on prices.
5. The theory considers only the medium of exchange function of money, while the store of the value function is ignored. All money is not used to buy goods. A part is stored, which will not affect prices.
6. The theory assumes full employment of resources which is not a normal situation for any country.
7. It is a static theory and unable to explain how the economy works. Prices and value of money may change even if the quantity of money is constant. Many other factors can bring change in prices e.g. tastes and spending habits etc.
8. The theory is simply a useless truism and fails to explain the process by which prices change. (e.g. 2=2 is a true statement. But it does not make any theory).
9. During the Great Depression of the 1930’s many countries tried to raise the general price level by increasing money supply but it did not work.
Conclusion
Although the quantity theory in its original and crude form is rejected, modern economics accepts that change in the quantity of money is a major factor of price changes.
Q.6) What are the chief causes of changes in the value of money? What affects changes in the value of money in different groups of society?
Answer:
Chief Causes of Changes in Value of Money
The following factors bring about changes in the value of money. If the prices are rising and the value of money is falling, it is called inflation.
1. Quantity of money
This is the most important determinant of the general price level and value of money. When people have more money at their disposal, naturally they are willing to offer higher prices and vice versa. Quantity of money increases for two reasons. Quantity of money increase either because of an increase in currency in circulation or increase in bank deposits created (credit money)
The rapid increase in the money supply has been a major cause of rising prices in Pakistan. Whereas in 1980, the total money supply was only 185 billion rupees. It swells to Rs. 6400 billion in April 2011. In the meanwhile, although the production of goods and services also increased many times, the increase in money supply has been much faster. The result is the inflation that we face today.
2. Velocity of Circulation
The velocity of circulation of money affects prices. If money changes hands more frequently, the prices tend to rise. If the velocity of circulation is low prices fall.
3. Population Growth
Increase in population means more demand for goods. If the rate of growth of population is faster than the rate of growth of goods and services, prices will start rising. Because of high population growth in Pakistan prices rise fast.
4. Decrease in Production
Change in the volume of production, other things remaining constant, has an inverse relation with the price level. If due to floods, drought, war or political disturbances, production of goods falls, prices tend to rise.
5. Deficit Budget
Deficit budget indicates that the government. expenditure exceeds tax revenue and it will borrow
money from banks who will expand credit money. Prices rise.
6. Increase in demand for goods
(Increase in consumption or hoarding) by the people is also a cause of rising in prices.
7. Imported Inflation
In this era of the global economy, a country may face inflation because of the high prices of imported goods. In Pakistan, a part of inflation is the result of expensive imports of oil and machinery.
8. Exchange depreciation or devaluation
If the exchange value of a country’s currency falls against foreign currencies, domestic prices rise. Devaluation of Pakistani rupees in 1972 and later depreciation in the exchange value of rupee created inflation.
9. Illegal and Easy Money
If some people are getting easy money through smuggling, corruption or political influence, they spend lavishly and carelessly. This raises the price level.
The factors, which cause a change in the price level usually, operate at the same time. For example, in Pakistan the quantity of money is increasing, the population is rising, the budget is in deficit, depreciation has occurred and imported inflation is lowering the value of Pak rupee.
Effects of Changes in Prices
Effect of change in the general price level is not the same for all. Some sections of society benefit while others suffer.
1. Fixed Income Groups
Rising prices hurt fixed-income groups of people. The persons getting income from rent, interest and salaries, have fixed incomes. When prices rise, the purchasing power of their fixed income falls. On the other hand, if prices fall they gain.
2. Business Community
The businessmen and industrialists gain from rising prices. Since their costs of rent, wages and interest remain fixed, while the prices of output rise, profits increase. When prices are falling, the business community suffers due to the shrinking of their profits.
3. Consumers
The rise in prices has an adverse effect on consumers. Their real income falls and they can buy less amount of goods with their incomes. When prices fall their capacity to buy goods with the given amount of money increases.
4. Working Classes
Working classes suffer from rising prices. Their wages do not rise at the rate prices do. So their real wages fall. During falling prices, such people gain.
5. Farmers
Farmers are happy during rising prices. The prices of farm products rise faster relative to industrial products.
6. Debtors and Creditors
If products rise, debtors gain while creditors lose. The debtors find it easier to pay off their debts, because of the rise in their incomes. The creditors get money and now have low purchasing power.
7. Investment and Employment
Since rising prices increase profits, investment is encouraged, which in turn creates more employment opportunities. Fall in prices has an adverse effect on investment activity and employment level.
8. Production
Rising prices have a positive effect on the production of goods and services. This happens because of the inducement of high profits.
9. Distribution of wealth
Inflation increases inequality in the distribution of wealth and incomes. The rich class mostly consists of big landlords, businessmen etc. rising prices bring higher incomes for this group. The wages of poor people working classes do not rise.
10. National Income
Although the rising prices harm many sections of the community, yet, as far as the collective interest of the people is concerned, slowly rising prices are better than falling prices because of production and employment level rise.
11. Savers
They are adversely affected by rising prices. Those who save and keep the amount as cash or in current accounts are losers when the trend of prices is upward.
If we consider all the plus and minus points of rising prices, we find that slowly rising prices are in the interest of the country. It will have a good effect on employment, investment, production, national income etc. but if prices start rising too fast, the economy will be badly affected. Falling of prices, in general, is not desirable. This is the lesson which governments and economists learnt after the Great Depression of 1930s. so the governments do not let prices fall.
Q.7) Discuss and criticize Fisher’s approach to the quantity theory of money.
Answer:
The quantity theory of money states that the quantity of money is the main determinant of the price level or the value of money. Any change in the quantity of money produces an exactly proportionate change in the price level.
In the words of Irving Fisher, “Other things remain 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.” If the quantity of money is doubled, the price level will also double and the value of money will be one half. On the other hand, if the quantity of money is reduced by one half, the price level will also be reduced by one half and the value of money will be twice.
Fisher has explained his theory in terms of his equation of exchange:
PT=MV+ M’ V’
Where P = price level, or 1 IP = the value of money;
M = the total quantity of legal tender money;
V = the velocity of circulation of M;
M’ – the total quantity of credit money;
V’ = the velocity of circulation of M;
T = the total amount of goods and services exchanged for money or transactions
performed by money.
This equation equates the demand for money (PT) to supply of money (MV=M’V). The total volume of transactions multiplied by the price level (PT) represents the demand for money.
According to Fisher, PT is SPQ. In other words, the price level (P) multiplied by quantity bought (Q) by the community (S) gives the total demand for money. This equals the total supply of money in the community consisting of the quantity of actual money M and its velocity of circulation V plus the total quantity of credit money M’ and its velocity of circulation V’. Thus the total value of purchases (PT) in a year is measured by MV+M’V’. Thus the equation of exchange is PT=MV+M’V’. In order to find out the effect of the quantity of money on the price level or the value of money, we write the equation as
P= MV+M’V’
Fisher points out the price level (P) (M+M’) provided the volume of trade remains unchanged. The truth of this proposition is evident from the fact that if M and M’ are doubled, while V, V and T remain constant, P is also doubled, but the value of money (1/P) is reduced to half.
Fisher’s quantity theory of money is explained with the help of Figure 65.1. (A) and (B). Panel A of the figure shows the effect of changes in the quantity of money on the price level. To begin with, when the quantity of money is M, the price level is P.
When the quantity of money is doubled to M2, the price level is also doubled to P2. Further, when the quantity of money is increased four-fold to M4, the price level also increases by four times to P4. This relationship is expressed by the curve P = f (M) from the origin at 45°.
In panel В of the figure, the inverse relation between the quantity of money and the value of money is depicted where the value of money is taken on the vertical axis. When the quantity of money is M1 the value of money is HP. But with the doubling of the quantity of money to M2, the value of money becomes one-half of what it was before, 1/P2. And with the quantity of money increasing by four-fold to M4, the value of money is reduced by 1/P4. This inverse relationship between the quantity of money and the value of money is shown by downward sloping curve 1/P = f (M).
Assumptions of the Theory
Fisher’s theory is based on the following assumptions:
1. P is a passive factor in the equation of exchange which is affected by the other factors.
2. The proportion of M’ to M remains constant.
3. V and V are assumed to be constant and are independent of changes in M and M’.
4. T also remains constant and is independent of other factors such as M, M, V and V.
5. It is assumed that the demand for money is proportional to the value of transactions.
6. The supply of money is assumed as an exogenously determined constant.
7. The theory is applicable in the long run.
8. It is based on the assumption of the existence of full employment in the economy.
Criticisms of the Theory:
The Fisherman quantity theory has been subjected to severe criticisms by economists.
1. Truism:
According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of exchange is a simple truism because it states that the total quantity of money (MV+M’V’) paid for goods and services must equal their value (PT). But it cannot be accepted today that a certain percentage change in the quantity of money leads to the same percentage change in the price level.
2. Other things not equal:
The direct and proportionate relation between quantity of money and price level in Fisher’s equation is based on the assumption that “other things remain unchanged”. But in real life, V, V and T are not constant. Moreover, they are not independent of M, M’ and P. Rather, all elements in Fisher’s equation are interrelated and interdependent. For instance, a change in M may cause a change in V.
Consequently, the price level may change more in proportion to a change in the quantity of money. Similarly, a change in P may cause a change in M. Rise in the price level may necessitate the issue of more money. Moreover, the volume of transactions T is also affected by changes in P. When prices rise or fall, the volume of business transactions also rises or falls. Further, the assumptions that the proportion M’ to M is constant, has not been borne out by facts. Not only this, M and M’ are not independent of T. An increase in the volume of business transactions requires an increase in the supply of money (M and M’).
3. Constants Relate to Different Time:
Prof. Halm criticizes Fisher for multiplying M and V because M relates to a point of time and V to a period of time. The former is a static concept and the latter a dynamic. It is therefore, technically inconsistent to multiply two non-comparable factors.
4. Fails to Measure Value of Money:
Fisher’s equation does not measure the purchasing power of money but only cash transactions, that is, the volume of business transactions of all kinds or what Fisher calls the volume of trade in the community during a year. But the purchasing power of money (or value of money) relates to transactions for the purchase of goods and services for consumption. Thus the quantity theory fails to measure the value of money.
5. Weak Theory:
According to Crowther, the quantity theory is weak in many respects. First, it cannot explain ’why’ there are fluctuations in the price level in the short run. Second, it gives undue importance to the price level as if changes in prices were the most critical and important phenomenon of the economic system. Third, it places a misleading emphasis on the quantity of money as the principal cause of changes in the price level during the trade cycle.
Prices may not rise despite increase in the quantity of money during depression; and they may not decline with reduction in the quantity of money during boom. Further, low prices during depression are not caused by shortage of quantity of money, and high prices during prosperity are not caused by abundance of quantity of money. Thus, “the quantity theory is at best an imperfect guide to the causes of the trade cycle in the short period” according to Crowther.
6. Neglects Interest Rate:
One of the main weaknesses of Fisher’s quantity theory of money is that it neglects the role of the rate of interest as one of the causative factors between money and prices. Fisher’s equation of exchange is related to an equilibrium situation in which rate of interest is independent of the quantity of money.
7. Unrealistic Assumptions:
Keynes in his General Theory severely criticized the Fisherman quantity theory of money for its unrealistic assumptions. First, the quantity theory of money for its unrealistic assumptions. First, the quantity theory of money is unrealistic because it analyses the relation between M and P in the long run. Thus it neglects the short run factors which influence this relationship. Second, Fisher’s equation holds well under the assumption of full employment. But Keynes regards full employment as a special situation. The general situation is one of under-employment equilibrium. Third, Keynes does not believe that the relationship between the quantity of money and the price level is direct and proportional.
Rather, it is an indirect one via the rate of interest and the level of output. According to Keynes, “So long as there is unemployment, output and employment will change in the same proportion as the quantity of money, and when there is full employment, prices will change in the same proportion as the quantity of money.” Thus Keynes integrated the theory of output with value theory and monetary theory and criticized Fisher for dividing economics “into two compartments with no doors and windows between the theory of value and theory of money and prices.”
8. V not Constant:
Further, Keynes pointed out that when there is underemployment equilibrium, the velocity of circulation of money V is highly unstable and would change with changes in the stock of money or money income. Thus it was unrealistic for Fisher to assume V to be constant and independent of M.
9. Neglects Store of Value Function:
Another weakness of the quantity theory of money is that it concentrates on the supply of money and assumes the demand for money to be constant. In order words, it neglects the store-of-value function of money and considers only the medium-of-exchange function of money. Thus the theory is one-sided.
10. Neglects Real Balance Effect:
Don Patinkin has criticized Fisher for failure to make use of the real balance effect, that is, the real value of cash balances. A fall in the price level raises the real value of cash balances which leads to increased spending and hence to rise in income, output and employment in the economy. According to Patinkin, Fisher gives undue importance to the quantity of money and neglects the role of real money balances.
11. Static:
Fisher’s theory is static in nature because of its unrealistic assumptions as long run, full employment, etc. It is, therefore, not applicable to a modern dynamic economy.
Q.8) Define inflation? What are its causes? How can it be controlled?
Answer:
Inflation
Inflation is an important and widely talked about concepts in modern economics. In simple words:
“Inflation means a situation in which there is a continuous rise in general price level”.
Rise in prices is only an indicator of inflation, otherwise inflation is an undesirable condition of the economy where supply of goods falls short of demand at current prices.
Coulborn beautifully defines the term as:
“Too much money chasing too few goods”.
Inflationary situation has three features.
a. There is a continuous rise in prices.
b. It starts when it becomes impossible to satisfy the whole demand for goods at
existing prices.
c. Inflation feeds on itself. After an initial rise in prices, the buyers anticipate further rise in prices and buy more quantities of goods in a hurry. This induces further rise in prices and inflation is propagated.
Causes of Inflation
The most important cause of rising prices is excessive increase in money supply. When people have more money to spend they increase demand. If the output does not grow at the same time, prices move up.
In broad terms inflation is of two types.
Demand-Pull Inflation
Some economists (called Keynesians) believe that inflation arises when total demand for goods (aggregate demand) exceeds supply at current prices. Demand for goods may arise due to many causes including increased money supply.
In an economy there are three main types of buyers, i.e. consumers, the investors (firms) and the government. If any of these groups increases its demand, while the demand of others remains the same, aggregate demand will rise. If aggregate supply of goods does not increase in the meanwhile (e.g. because the economy is working at full employment), then prices of goods start rising. For example, if the government spends large amounts of money on development projects, inflation may take place. Greater part of inflation in Pakistan is of the demand-pull type.
Factors which act on the demand side of prices include, deficit financing & excessive increase in money supply, population explosion, hoarding and artificial scarcity of goods, black money, concentration of wealth and unproductive expenditure development expenditure.
Cost-Push Inflation
Some economists think that a major part of inflation originates from rise in production costs. When the firms pass on their increased costs to consumers in the form of higher prices of products, inflation takes place. Important sources of rise in cost include workers’ demand for higher wages, profiteering, increase in taxes and high prices of imports.
Control of Inflation
Inflation needs to be controlled effectively before it gets out of hand. Since the main cause of inflation is the existence of excessive demand, most of the measures should be directed to decrease aggregate demand for goods. In the long run, however, increase in supply of goods can be the best solution.
Three kinds of policies are used to control inflation:
1. Monetary policy.
2. Fiscal policy.
3. Direct or physical measures.
Monetary policy is used to control the supply of money and cost of borrowing. The central bank acts in two directions.
a. It reduces the supply of money in circulation.
b. It raises the interest rate (Discount rate) which discourages borrowing from the banks. As a result total money supply is reduced.
Fiscal policy, which refers to the government policy of public expenditure and taxes, can be used as an anti-inflationary measure. The government reduces its expenditure on unproductive activities. It raises direct taxes which decrease disposable income of the consumers and aggregate demand for goods falls.
Direct measures means the steps of the government like rationing of goods and freezing of prices and wages. The government can also increase voluntary savings of the people by giving them various incentives. However, in a free economy, direct controls can succeed only for a very short period.
Conclusion to control inflation, as a short run measure, aggregate demand for goods must be controlled. For a long run solution, all those measures which increase supply of goods are helpful. Slowing the rate of growth of population has also a healthy effect (this is especially needed in case of Pakistan).
Q.9) What are the causes of inflation in Pakistan ? How this inflation can be controlled.
Answer:
CAUSES
Demand-Pull factors
1. Deficit financing & excessive increase in money supply
The major cause of rising prices is deficit financing which the government uses to finance development expenditure. Money supply which was Rs. 185 billion in 1980, rose to above Rs. 6330 billion in end April 2011. On the other side, because the increase in production was not at the same rate, the level of price rose.
2. Population explosion
Our population is rising at a very fast rate i.e. 2% while the rate of GNP growth is slow. Increase in national output is insufficient to remove scarcity of goods. Since independence, our population has exceeded five times. In the coming years, population will be the most important hurdle in controlling inflation.
3. Profiteering, hoardings and artificial scarcity of goods
Hoarding is a common evil in our country. Frequently, artificial scarcity of essential items is created. (e.g. food items, cement, fertilizer) and huge profits are charged. Similarly, through smuggling, large quantities of essential goods are sent to Afghanistan.
4. Black money, concentration of wealth and unproductive expenditure
In Pakistan a lot of people have black money. Mostly, this money is not spent on productive activities. Either it goes to real estate, jewellery, speculation, expensive marriages or it is carelessly spent on consumer goods (e.g. excessive use of AC, transport). All additional expenditure puts pressure on prices. (e.g. price of meat).
5. Development expenditure
Long run expenditure on mega development projects like Gwadar Port increases total spending in the country and raises incomes and demand for goods but production from such projects takes a long time to be available.
Cost- Push Factors (affecting supply of goods)
6. Depreciation in exchange value of rupee against foreign currencies is a source of inflation.
7. Political instability
Political instability discourages investment and encourages speculation and hoarding. Industrialists and businessmen feel insecure and cannot make good plans. Frequent rumors about political change create fear among investors.
8. Imported inflation and high oil price
Prices of imported goods continuously rise. As a result Pakistan’s domestic prices increase. Rise in oil price affects all other prices.
9. Wages increases
The increase in wages of workers has also contributed to inflation. Increase in wages result in higher cost of production of goods. So their prices rise.
10. Indirect taxes
Taxes on commodities like sales tax and excise duty push up prices of goods.
11. Climatic and natural factors
Pakistan’s economy heavily depends upon agriculture. But due to weather conditions many crops fall short of target, thus pushing up prices.
MEASURES TO CONTROL INFLATION
Existence of inflation in a country means that demand for goods exceeds supply at the existing prices. So to control inflation:
§ Take steps to control demand for goods
§ Adopt policies to increase supply of goods and services.
A. On supply side
1. Increase of output
The most effective method to control inflation is to increase the supply of goods. Industrial and agricultural output should be increased. However Pakistan’s performance in this regard is unsatisfactory.
2. Control of smuggling, hoarding and speculation
Smuggling of wheat, ghee and other essential commodities to Afghanistan should be strictly checked.
3. Industrial peace
Industrial peace should be ensured to maintain the supply of goods and avoid the danger of scarcity. The disturbances such as what happened at Karachi during past years should be controlled.
4. Cheap Sources of Energy
Cheap sources of energy are needed to reduce cost of production. Efforts should be doubled to increase local production of oil and nuclear energy. New dams and power plants run by coal should be constructed on priority basis.
B. On demand side
1. Control of Money Supply
Volume of credit and money supply should be controlled i.e. tight monetary policy be followed. Decrease in money supply means purchasing power with the people.
2. No deficit financing
Deficit financing should be discontinued. The development expenditure of the budget deficit should be met through taxation or borrowing and not by printing new money.
3. Population control
Growth of population must be slowed. The campaign of population planning has already started showing some success.
4. Simple living
Luxurious lifestyle should be discouraged and simple living is promoted. The political leaders should set examples of simple living to be followed by others. Heavy taxes should be levied on luxury items.
5. Price control
Prices of essential commodities should be controlled. The demand and supply situation in markets of such commodities should be constantly reviewed and as soon as some trouble appears, appropriate steps should be applied.
MEASURES TAKEN BY GOVERNMENT
1. Fiscal measures: Increase in tax collection decreases the need for deficit financing which is the major source of inflation. The government is trying to reduce the budget deficit by collecting more taxes. Tax evasion is being checked. The government has also taken measures to decrease its non-development expenditure.
2. Monetary Measures: The state bank has adopted various steps to control credit expansion. It has raised the discount rate and reserve ratio. The bank has banned the use of credit for speculation purposes.
3. Saving schemes: The government has initiated various schemes to promote savings e.g. Pakistan investment bonds, prize bonds, defense saving certificates, NIT units. The issuance of bonds and sukuks is useful for national savings.
4. Export and Import duties: The government has increased export duties and reduced import duties on various essential items. Whenever there is shortage of some items, the government allows imports of these e.g. sugar, wheat and pulses.
5. Other measures: The government has established price stabilization boards, price review committees, price commission to watch rise in prices.
Utility Stores: The government runs utility stores to discourage private businessmen from charging excessive profits. Utility stores supply essential commodities such as wheat flour, sugar, pulses and cooking oil at less than market prices.
Q.10) Write note on deflation
Answer:
DEFLATION
Deflation is a situation of an economy in which enough aggregate demand for goods is not coming and, as a result, prices fall. During deflation profits of firms decrease or even losses occur. Unemployment rises and the economy comes under depression. Men and machines become idle because people have no purchasing power to buy goods. Investment activity stops and bank credit shrinks.
Causes
Deflation can occur due to the following reasons.
i. The government decreases its expenditure which causes a decrease in aggregate demand for goods in the country.
ii. Banks follow a tight money policy and reduce lending. Due to less credit available, the firms make less investment.
iii. Due to some set back the export sector performs poorly. Exporters are unable to sell their product. For example, during the Gulf war in early 1991, Pakistani’s exports to the Middle East were affected.
Control
To control deflation spending by government and private sector has to be increased
- i. Expenditure on public works like schools and roads should be increased. This will increase the income of the workers, which will be used to buy goods.
- ii. The government should increase the purchasing power of the people by increasing transfer payments such as pensions and unemployment allowance.
- iii. Private investment should be encouraged by easy credit policy of banks and tax concessions by the government.
- iv. Rate of taxation should be reduced to increase people’s disposable income.
- v. The government can use deficit financing to increase the money supply in circulation.
