Managerial Economics - Inflation and Deflation PDF

Managerial Economics Manipal University Jaipur (MUJ) MASTER OF BUSINESS ADMINISTRATION SEMESTER 1 MANAGERIAL ECONOMICS Unit 15: Inflation and Deflation 1 Managerial Eco...

Managerial Economics Manipal University Jaipur (MUJ) MASTER OF BUSINESS ADMINISTRATION SEMESTER 1 MANAGERIAL ECONOMICS Unit 15: Inflation and Deflation 1 Managerial Economics Manipal University Jaipur (MUJ) Unit 15 Inflation and Deflation Table of Contents SL Fig No / Table SAQ / Topic Page No No / Graph Activity 1 1.Introduction - - Case Let - - 3–4 Learning Objectives - - 2 Inflation - Meaning - - 2.1 Types of Inflation 1, 2 - 5 – 16 2.2 Causes of Inflation - - 2.3 Effects of Inflation - - 3 Measures to Control Inflation - - 3.1 Monetary Measures - - 3.2 Fiscal Measures - - 17 – 23 3.3 Other Measures – Direct or 3,4 - Administrative Measures 3.4 The Inflationary Gap - - 4 Deflation - 1 4.1 Meaning - - 24 – 29 4.2 Effects of Deflation - - 4.3 Methods to Control Deflation - - 5 Summary - - 30 6 Glossary - - 31 7 Terminal Questions - - 32 8 Answers - - 32 – 33 9 Case Study - - 33 – 34 10 References - - 35 Unit 15: Inflation and Deflation 2 Managerial Economics Manipal University Jaipur (MUJ) 1. INTRODUCTION In the previous unit, we analyzed the meaning, features, and theories of business cycles. We learnt the measures to control business cycles and the relationship between business cycles and business decisions. Businesscycles have significant impacts on the prices of goods and services that are supplied by firms, as well as the inputs used by the firms in their production processes. The level of prices is determined by various factors. A steadyrise in price level is termed as inflation. Inflation is generally considered as amonetary phenomenon caused by an excess supply of money. There are different kinds of inflation – demand-pull inflation, cost-push inflation, etc. Inflation is caused by a number of factors such as an increase in the supply of money, income, exports, consumption, etc., on the demand side. On the supply side, inflation is caused by shortage in the supply of factors ofproduction, operation of the law of diminishing returns, war, hoarding, etc. The effects of inflation are different in different sections of society. A mild inflation is beneficial to the economic growth as producers and business men are benefited by it. But when it assumes larger proportions, it becomes dangerous to the growth of the economy and is painful to the consumersand laborers. A number of anti-inflationary measures like monetary, fiscal, and administrative are adopted to control inflation. The concept of inflationary gap was first developed by J.M. Keynes, which means ‘an excess of anticipated expenditure over available output at a base price’. Phillips curve explains the relationship between inflation and unemployment. Stagflation is a new concept developed to explain the situation of stagnant conditions in economic activity when there is inflation in the economy. Deflation is just the opposite of inflation. It is essentially a period of falling prices and a rise in the value of money. Deflation is more dangerous than inflation. Unit 15: Inflation and Deflation 3 Managerial Economics Manipal University Jaipur (MUJ) Case Let (Continued from Unit 14) Ramesh discussed the issue of fluctuating sales with his superiors who told him that macroeconomic conditions in the economy affected the industry’s performance at the economy level, while various internal factors and competitions impacted the performance of individual firms. While analysing the price data for various periods of time, Ramesh felt that the impact of rising prices should be discounted from the nominal prices to calculate the real prices. He felt that this would be necessary to know if the increase in prices, if any, matched/exceeded/trailed the change in the overall price levels. He collected the price level data that was published by the government authorities. However, he wasn’t sure whether he should use numbers that were labelled as wholesale price index or those labelled as consumer price index. He tried to collect the price index for traverse rods for the entire country but found that such data was not available. He then approached his former teacher of economics who explained the practical relevance of the concepts ofinflation/deflation and price index. Learning Objectives: After studying this unit, you should be able to: ❖ Define inflation and distinguish between different kinds of inflation ❖ Describe the causes of inflation and its effects on different sections of society ❖ Explain different measures that can be adopted to control inflation ❖ Analyse the concept of inflationary gap ❖ Evaluate suitable measures to tackle the situation of stagnation ❖ Examine the impact of deflation on the performance of business firms Unit 15: Inflation and Deflation 4 Managerial Economics Manipal University Jaipur (MUJ) 2. INFLATION - MEANING Inflation has become a global phenomenon in recent years. Economic development is also associated with inflation. An in-depth study of inflation is of paramount importance to a student of managerial economics. The term inflation is used in various scenarios and hence it is very difficult to give a generally accepted, universally agreeable, and precise definition to the term inflation. Popularly, inflation is associated with high prices, which causes a decline in the value of money. Inflation is commonly understood as a situation of substantial and rapid increase in the level of prices and consequent deterioration in the value of money over a period of time. It refers to the average rise inthe general level of prices and fall in the value of money. Inflation is an upward movement in the average level of prices. The opposite of inflation is deflation, a downward movement in the average level of prices. The common feature of inflation is the rise in prices and the degree of inflation may be measured by price indices. Inflation is statistically measured in terms of percentage increase in the price index, as a rate (percent) per unit of time- usually a year or a month. The trend of price indices reveals the course of inflation in the economy. Usually, the Wholesale Price Index (WPI) numbers are used to measure inflation. Alternatively, the Consumer Price Index (CPI) or the cost-of-living index can be adopted to measure the rate of inflation. In order to measure the percentage rate of inflation, the following formula can be used: CPI in current Year – CPI in previous Year Inflation Rate = × 100 CPI in previous year CPI = Consumer price index Most economists considered inflation as a purely monetary phenomenon. According to this approach, it is the increase in the quantity of money which causes an inflationary rise in the price level. An expansion in money supply unaccompanied by an expansion in the supply of goods and services inevitably results in price rise. Inflation exists when the amount of money in the country is in excess of the physical volume of goods and services. It is a situation where too much money chases too few goods. Money supply and rising price level are both causes and effects by themselves. Unit 15: Inflation and Deflation 5 Managerial Economics Manipal University Jaipur (MUJ) Inflation is that state of disequilibrium in which an expansion of purchasing power tends to cause an effect of an increase in the price level. Some economists state that inflation is always and everywhere a monetary phenomenon. The classical economists advocated quantity theory of moneyand they analyzed the causes of inflation in terms of money. This approach failed to explain the causes of hyperinflation, which appeared in Germany after the First World War. This theory is not applicable to an economy suffering from depression and unemployment. The Cambridge economists such as Lord Keynes and A.C Pigou viewed inflation as a phenomenon of full employment. According to Keynes “an inflationary rise in price cannot take place before the point of full employment”. This means that when there is under employment, the government ensures there is an expansion of money supply which is used by businesses to increase production of goods and services and during this time there is an expansion in employment as the unemployed resources (labor) are hired to do extra production. This is the reason why Keynes suggests that inflation is a phenomenon that happens only when there is full employment. Therefore, any and every rise in price level is not termed as inflation. Any rise in price level before the point of full employment is called “semi- inflation” or “bottleneck inflation”. This will continue till all unemployed men and other resources are fully employed. Beyond this stage, any increase inmoney supply will lead only to a rise in prices, but not a rise in production and employment. Hence, according to Keynes, the rise in price level after the point of full employment and when production does not increase is the true inflation. According to another approach, the sole cause of inflation is the existence of a persistent excess demand in the economy. Inflation is the excess demand for the supply of everything after the limits of the supply have been reached. 2.1 Types of inflation Depending upon the rate of rise in prices and the prevailing situation, inflation has been classified into the following six types: Unit 15: Inflation and Deflation 6 Managerial Economics Manipal University Jaipur (MUJ) Creeping inflation – When the rise in prices is very slow (less than 3%) like that of a snail or creeper it is called creeping inflation. Walking inflation – When the rise in prices is moderate (in the range of 3 to 7%) and the annual inflation rate is in the single digit it is called walking inflation. It is a warning signal for the government to control it before it turns into running inflation. Running inflation – When the prices rise rapidly at a rate of 10 to 20% per annum it is called running inflation. Such inflation affects the poorand middle classes adversely. Its control requires strong monetary and fiscal measures; otherwise, it can lead to hyperinflation. Hyperinflation – Hyperinflation is also called by various names like jumping, runaway, or galloping inflation. During this period, prices rise very fast (double- or triple-digit rates) at a rate of more than 20 to 100% per annum and become absolutely uncontrollable. Such a situation brings a total collapse of the monetary system because of the continuous fall in the purchasing power of money. Demand-pull Inflation – The total monetary demand persistently exceeds the total supply of goods and services at current prices so that prices are pulled upwards by the continuous upward shift of the aggregate demand function. It arises as a result of an excessive aggregate effective demand over aggregate supply of goods and services in a slowly growing economy. Supply of goods and services will not match the rising demand. The productive ability of the economy is so poor that it is difficult to increase the supply at a quicker rate to match the increase in demand for goods and services. When exports increase, the income of people rises. With excess money income, purchasing power, demand, and prices move in theupward direction. It is essential to note that the demand-pull inflation is the result ofan increase in money supply. This leads to the following: Decrease in the interest rate, Increase in investment Unit 15: Inflation and Deflation 7 Managerial Economics Manipal University Jaipur (MUJ) Increase in production Increase in the incomes of factors of production Increase in the demand for goods and services Increase in the level of prices Thus, excess supply of money results in escalation of prices. Again, when there is a diversion of productive resources from the production of consumer goods to either capital or defense goods or non-essential goods, prices start rising in view of scarcity of consumer goodsand excess income in the hands of people. It is clear from Figure 1. Source: Economics for managers by Geetha M Rajaram. Figure 1: Demand-pull inflation In the figure, X axis shows the price level (PL) and Y axis shows the GDP. LRAS is a long run aggregate supply curve. AD1 Aggregate demand 1 and AD2 Aggregate demand 2 curves. Point A indicates the equilibrium position where aggregate demand is equal to aggregate supply of goods and services. OP1 is the price level and OY1 indicates the supply of goods and services. As demand increases, supply being constant, the price level rises from OP1 to OP2. Cost-push inflation – Prices rise on account of the increasing cost of production. When businesses respond to rising unit costs by increasing their prices to protect the profit margins. When manufacturers or businesses raise prices as a measure to balance other increase in production cost. Thus, in this case, the rise in price is initiated by growing factor costs. Hence, such a price rise is termed as ‘cost-push’ Unit 15: Inflation and Deflation 8 Managerial Economics Manipal University Jaipur (MUJ) inflation as prices are being pushed up by rising factor costs. A number of factors contribute to the increase in the cost of production. They are: Demand for higher wages by the labor class. Fixing of higher profit margins by the manufacturers. Rise in indirect taxes, Introduction of new taxes and raising the level of old taxes. Increase in the prices of different inputs and raw materials in the market. Rise in administrative prices by the government. A fall in the external value of the exchange rate leads to a rise in the prices of goods and commodities that have to be imported. These factors, in turn, cause prices to rise in the market. Out of the many causes, the rise in wages is the most important one. It is estimated and believedthat wages constitute nearly 70% of the total cost of production. A rise in wages leads to a rise in the total cost of production and a consequent rise inthe price level. Thus, cost-push inflation occurs due to wage-push or profit-push. We can explain the cost-push inflation with the help of Figure 2. Figure 2: Cost-push inflation Now, at the price Op, the demand is Oq but the supply is Oq2 which is lesser than Oq. Therefore, the prices are pushed high till a new equilibrium is reached at Op1. At this point, there is no excess demand. Hence, you can see that inflation is a self-limiting phenomenon. In the graph above, the equilibrium price is Op and the equilibrium output is Oq. If the aggregate supply falls, then the supply curve SS shifts left to reach S1S1. Unit 15: Inflation and Deflation 9 Managerial Economics Manipal University Jaipur (MUJ) 2.2 Causes of Inflation I. Demand side Increase in aggregative effective demand is responsible for inflation. In this case, aggregate demand exceeds aggregate supply of goods and services. Demand rises much faster than supply. We can consider the following reasons for the increase in effective demand. Increase in money supply – Supply of money in circulation increases on account of the following reasons: deficit financing by the government, expansion in public expenditure, expansion in bank credit and repayment of past debt by the government to the people, increase in legal tender money and public borrowing. Increase in disposable income – Aggregate effective demand rises when disposable income of the people increases. Disposable income rises on account of the following reasons: reduction in the rates of taxes, increase in national income while tax level remains constant, and decline in the level of savings. Increase in private consumption expenditure and investment expenditure – An increase in private expenditure both on consumption and on investment leads to emergence of excess demand in an economy. When business is prosperous, business expectations are optimistic and prices are rising. More investments are made by private entrepreneurs causing an increase in factor prices. When the income of the factors rises, there is more expenditure on consumer goods. Increase in exports – An increase in the foreign demand for a country’sexports reduces the stock of goods available for home consumption.This creates shortages in the country leading to a rise in price level. Existence of black money – The existence of black money in a country due to corruption, tax evasion, black-marketing, etc. increases the aggregate demand. People spend such unaccounted money extravagantly and create unnecessary demand for goods and services thus causing inflation. Unit 15: Inflation and Deflation 10 Managerial Economics Manipal University Jaipur (MUJ) Increase in foreign exchange reserves – This may increase on account of the inflow of foreign money into the country. Foreign direct investment may increase and non- resident deposits may also increase due to the policy of the government. Increase in population growth – This creates an increase in demand for many types of goods and services in a country. High rates – Higher rates of indirect taxes would lead to a rise in prices. Reduction in the rates of direct taxes – This would leave more cash inthe hands of people, inducing them to buy more goods and services, leading to an increase in prices. Reduction in the level of savings – This creates more demand for goods and services. II. Supply side Generally, the supply of goods and services does not keep pace with the ever-increasing demand for goods and services. Thus, supply does not match thedemand. Supply falls short of demand. Increase in supply of goods and services may be limited because of the following reasons. Shortage in the supply of factors of production – When there is shortage in the supply of factors of production like raw materials, labor, capital equipment, etc. there will be a rise in their prices. Thus, when supply falls short of demand, a situation of excess demand emerges with rising factor prices creating inflationary pressures in an economy. Operation of law of diminishing returns – When the law of diminishing returns operates, an increase in production is possible only at a higher cost which demotivates the producers to invest in large amounts. Thus, production will not increase proportionately to meet the increase indemand. Hence, supply falls short of demand. Hoardings by traders and speculators – During the period of shortage and rise in prices, hoardings of essential commodities by traders and speculators with the objective of earning extra profits in the future creates an artificial scarcity of commodities. This creates a situation of excess demand paving the way for further inflation. Unit 15: Inflation and Deflation 11 Managerial Economics Manipal University Jaipur (MUJ) Hoardings by consumers – Consumers may also hoard essential goods to avoid payment of higher prices in the future. This leads to an increase in the current demand, which in turn stimulates prices. Role of trade unions – Trade union activities leading to industrial unrestin the form of strikes and lockouts also reduce production. This will lead to the creation of excess demand that eventually brings a rise in the price level. Role of natural calamities – Natural calamities such as earthquake, floods, and drought conditions also affect the supplies of agricultural products adversely. They also create a shortage of food grains and raw materials, which in turn creates inflationary conditions. War – During the period of war, shortage of essential goods creates a rise in prices. International factors – These factors would cause either a shortage of goods and services or a rise in the prices of factor inputs, leading toinflation. E.g., higher prices of imports. Increase in prices of inputs within the country III. Role of expectations Expectations also play a significant role in accentuating inflation. Thefollowing points are worth mentioning: If people expect further rise in price, the current aggregate demandincreases, which in turn causes a rise in the prices. Expectations about higher wages and salaries affect the prices ofrelated goods. Expectations of wage increase often induce some business houses toincrease prices even before upward wage revisions are actually made. Thus, many factors are responsible for the escalation of prices. 2.3 Effects of inflation The positive effects of inflation are as follows: Unit 15: Inflation and Deflation 12 Managerial Economics Manipal University Jaipur (MUJ) Rise in investment – Rise in prices leads to a rise in profits, incomes, savings, and finally the volume of investment by entrepreneurs. Encourages entrepreneurship – As profits rise, it encourages entrepreneurs to enter into business in an increasing manner. Increase in the demand for money – As prices rise, people require more money to buy the same quantity of goods and services. Hence, it leads to an expansion in money supply in the country, which leads to a higher growth rate in the economy. A low inflation rate stimulates economic growth – A small amount of inflation is often viewed as having a positive effect on the economy. For example, mild inflation has a stimulating or tonic effect on the economy. Rise in price leads to increase in profit ratio, investment,output, employment, and income in an economy. Entrepreneurs and business community gain – Businessmen welcome inflation as they gain from the rising prices. Their inventory value rises. The price of finished products rises much faster than the production costs. Hence, their profit margins would also go up substantially. Effects on investors – If investors invest their capital in equity shares and debentures, they stand to gain because their prices are rising. On the other hand, if they invest in bonds and securities, they lose because their incomes from them remain the same. Effects on farmers – Virtually, farmers are the gainers because prices of agricultural goods rise on one hand. On the other hand, the cost of cultivation lags behind prices received. Inflation favors one group at the expense of other groups. It is generally regressive in nature as many people cannot protect their own self-interests. The adverse effects of inflation are as follows: Disturbs the working of price mechanism – The most harmful effect of inflation is that it disrupts the smooth working of the price mechanism and economic system and as a consequence, economic adjustments become very difficult. Inflation leads to balance of payments problems - When domestic prices rise faster than prices in foreign countries, exports tend to lag behind imports. The rate of Unit 15: Inflation and Deflation 13 Managerial Economics Manipal University Jaipur (MUJ) exchange also tends to depreciate on both accounts of the falling purchasing power of the currency within the country and adverse balance of payments. Adverse effects on investment and production – Rise in price leads to a fall in the value of money, reduction in purchasing power, reduced savings and investment. On account of the fall in the rate of capital formation, the total volume of production declines. Adverse effects on savings and capital formation – Due to rise in prices there is an effect on household savings. Capital formationsuffers as a consequence of depreciation in the value of money. It weakens the financial system of the country. Similarly, it discourages the inflow of foreign capital into the country and at times results in the outflow of capital. Business uncertainty – Production will be adversely affected on account of business uncertainty. A sort of tension prevails during the period of inflation which discourages entrepreneurs from taking risks involved in production. Hoardings and black marketing – During inflation, traders hoard essential goods with a view to getting higher profits. The buyers also hoard essential goods for fear of paying higher prices in the future. Thus, it also leads to the growth of black marketing. Sellers’ market – During inflation, a sellers’ market develops. As prices are rising, people want to sell their goods rather than buy them. The qualityof goods and services also will be affected by inflation. Speculative activity – Speculative activities gain momentum duringinflation. Distortion in resource allocation – It leads to diversion of resources from productive uses to unproductive uses with the sole objective of earning more profits by the entrepreneurs. With the rise in prices, the costs of development projects will also go up leading to more diversion of resources to complete the same project by the government. Effects on distribution Unequal distribution of income and wealth – Prolonged and persistent inflation leads to inequitable distribution of wealth and income in society. Inflation robs the poor to Unit 15: Inflation and Deflation 14 Managerial Economics Manipal University Jaipur (MUJ) enrich the rich. Rich entrepreneurs earn more profits at the cost of customers. This leads to unequal distribution of income and wealth as the rich become richer and poor become poorer. Hardships for fixed income earners – Rentiers and bond holders with fixed rates of interest, holders of government securities, persons who live on past savings, pensioners, etc., are adversely affected as their monetary income remains the same while the value of money falls. Debtors gain and creditors lose – Generally, during inflation, debtors gain as they return the borrowed money when its face value is less and creditors lose because they get back their money with depreciation in its value. Adverse effects on wage-earners and salaried class – The wage earners, salaried class, and middle-class people are worst affected as their living standards deteriorate due to escalation of prices while their incomes remain the same. Social and political effects of inflation Social effects – Inflation is a powerful engine of wealth distribution in favor of the rich. It widens the gap between the rich and the poor and thus hampers social justice. It leads to social inequalities. Moral and ethical effects – In order to earn higher profits, businesses resort to black marketing, adulteration, smuggling, hoarding, quality deterioration, and other anti- social tactics. Hence, inflation gives a serious blow to business morality and ethics. General morality declines and corruption increases. This leads to overall discontent among people. Political effects – Deterioration in social and ethical standards and discontent among the people reflected in political uncertainty. People lose faith in the administrative ability of the government, which gives way to an explosive political situation in the country. Hyperinflation in Germany during the 1920s is a glaring example of the rise of Hitler as a dictator. It has been rightly said that, “Hitler is the foster-child of inflation”. Demonstration effect – It encourages consumerism and a country may have to suffer on account of demonstration effects. Unit 15: Inflation and Deflation 15 Managerial Economics Manipal University Jaipur (MUJ) External effects of inflation Volume of exports – It reduces the volume of exports of a nation as domestic prices are much higher than international prices. Exchange rate difficulties – Fall in the value of home currency may reduce external value of a currency and thus create problems in the determination of exchange rate between the currencies of different countries. Inflow of foreign capital – It discourages the inflow of foreign capital into a country. International competitiveness – If a country experiences a higher rateof inflation as compared to other nations, the internationalcompetitiveness of the given country will decline. Thus, inflation has far-reaching consequences on the economy of a country. Unit 15: Inflation and Deflation 16 Managerial Economics Manipal University Jaipur (MUJ) 3. MEASURES TO CONTROL INFLATION The measures to control inflation (anti-inflationary measures) are broadly classified into three categories. I. Monetary Measures Inflation is basically a monetary phenomenon. Excess money supply over the quantity of goods and services is mainly responsible for the rise in prices. Hence, monetary authorities aim at reducing and absorbing excess supplyof money in an economy. The following are some of the anti-inflationary monetary measures: 1. The volume of legal tender money may be reduced either by withdrawing a part of the notes already issued or by avoiding large-scaleissue of notes. 2. Restrictions on bank credit. 3. Freezing and blocking particular types of assets. 4. Increasing bank rates and other interest rates. 5. Sale of government securities in the open market by the central bank. 6. Raising the legal reserve requirements like CRR and SLR. 7. Prescribing a higher margin that bank and other lenders must maintainfor the loans granted by them against stocks and shares. 8. Regulation of consumer credit. 9. Rationing of credit. Thus, the government may exercise various quantitative and qualitativetechniques of credit controls to control inflation. II. Fiscal Measures The following are some of the important anti-inflationary fiscal measures: 1. Reduction in the volume of public expenditure. 2. Rise in the levels of taxes, introduction of new taxes, and bringing morepeople under the coverage of taxes. Unit 15: Inflation and Deflation 17 Managerial Economics Manipal University Jaipur (MUJ) 3. More internal borrowings by public authorities. 4. Postponing the repayment of debt. 5. Control on the volume of deficit financing. 6. Preparation of a surplus budget. 7. Introduction of compulsory deposit schemes. 8. Incentive to savings. 9. Diverting the public expenditure towards the projects where the time gap between investment and production is least (small gestation period). 10. Tariffs should be reduced to increase imports and thus allow a part of the increased domestic income to ‘leak out’. 11. Inducing wage earners to voluntarily buy government bonds, securities,etc. Thus, fiscal measures succeed to a greater extent to contain inflation in its own way. III. Other Measures – Direct or Administrative Measures Direct controls refer to the regulatory or administrative measures taken by the government directly with an objective of controlling the rise in prices. Modern governments directly intervene in the working of the economy in several ways. Hence, the governments take several concrete measures to check the rise in prices. The following are some of the direct measures taken by modern governments. 1. Expansion in the volume of domestic output so as to meet the ever-increasing rise in the demand for them. Increasing the production of essential consumer goods like food, clothing, sugar, vegetable oil, etc. 2. Direct control of prices by fixing an upper limit for prices of essential consumer goods and introduction of rationing that aims at distributing consumption of scarce goods so as to make them available to a large number of consumers. It is applied on commodities like wheat, rice, kerosene sugar, edible oil to ensure distributive justice and stabilize the prices. 3. Control of speculative and gambling activities. Unit 15: Inflation and Deflation 18 Managerial Economics Manipal University Jaipur (MUJ) 4. Wage – profit freeze by adopting appropriate wage-profit policy. 5. Adopting an appropriate income policy. 6. Introducing the latest technology, raw materials, financial help, subsidies should be provided for different consumer goods sectors to increase production. 7. Overvaluation of currency Overvaluation of domestic currency in terms of foreign currencies in order to increase imports to add to the stocks within the country and decrease in exports so that more goods will become available for domestic consumption. 8. Indexing Indexing refers to monetary corrections by periodic adjustments in money income of the people and in the value of financial assets, saving deposits, etc. held by the public in accordance with the changes in price level. E.g., if prices rise by 15%, the income and the value of the financial assets should be increased by 15% under the system of indexing. 9. Control of population This is considered as one of the most important methods because if population is controlled it is possible to keep a check on the demand forgoods and services. 10. Exhortations This implies authoritative persuasions, publicity campaigns, national savings campaign, requests to trade union for voluntary resistance to demand for rise in wages, companies to restrict dividend distributions to workers, and management to increase productivity and output, etc. The above-said measures are to be employed in a judicious manner in order to combat inflation in a country. Unit 15: Inflation and Deflation 19 Managerial Economics Manipal University Jaipur (MUJ) The Inflationary Gap J. M. Keynes invented the term ‘inflationary gap’ to describe a situation when there is “excess of anticipated expenditure over the available output at base prices.” It is a gap between money incomes of the community and the available supply of output of goods and services. According to Lipsey “The inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income.” The larger the aggregate expenditure, the larger the gap and more rapid the inflation. During a war, the volume of money expenditure by the government increases resulting in increased income within the community. This leads to increased consumption expenditure and investment. Given a constant average propensity to save, rising incomes at full employment level led to an excess of demand over supply and resulted in the development of inflationary gap. We can explain this with an illustration: (Rs. crore) 1. Gross national income at current prices 20,000 2. Less taxes 5,000 3. Personal income (gross disposable income) 15,000 4. Less savings in the community 3,000 5. Disposable income 12,000 6. Gross national product at pre-inflation prices 15,000 7. Government expenditure (to meet the war requirements) 6,000 8. Output available for consumption at pre-inflation prices 9,000 9. Inflationary gap (12,000 – 9,000) ---------------------- 3,000 Now, the net disposable income with the community is 12,000, but the available output for civilian consumption is only 9,000. There is an excess ofdemand for the available supply to the extent of Rs.3000 crore. This is referred to as the inflationary gap. Though Keynes associated an inflationary gap with war, such a gap can arise even during the period of economic development. We can show the inflationary gap diagrammatically using the Keynesian concepts of aggregate supply and aggregate demand: 0 YF Y1 Income / Employment Unit 15: Inflation and Deflation 20 Managerial Economics Manipal University Jaipur (MUJ) Figure 3: ‘Interaction of aggregate demand and aggregate supply’ Y is the full employment level of income. The 45-degree line represents aggregate supply (AS) and C+I+G line (AD). The community’s aggregate demand curve intersects the aggregate supply curve at E, at OY1 level of income, which is greater than the full employment level of income YF. The amount by which aggregate demand (YFA) exceeds the aggregate supply (YFB) at the full employment level of income is the inflationary gap (AB). Measures to wipe out inflationary gap The following are the measures to wipe out the inflationary gap: 1. Increase in savings to reduce aggregate demand. 2. Raise the output to match the disposable income. 3. Raise the taxes to clear the excess purchasing power. The first two measures have a limited scope. Monetary policy also cannot be very effective and so the government will have to rely more on fiscal measures like taxation to wipe out the inflationary gap. Stagflation The present-day inflation is the best explanation for stagflation in the whole world. It is inflation accompanied by stagnation on the development front in an economy. Instead of leading to full employment, inflation has resulted in unemployment in most of the countries Unit 15: Inflation and Deflation 21 Managerial Economics Manipal University Jaipur (MUJ) of the world. It is a global phenomenon today. Both developed and developing countries are not free from its clutches. Stagflation is a term in macroeconomics used to describea period with a high rate of inflation combined with unemployment and economic recession. Inflationary gap occurs when aggregate demand exceeds the available supply and deflationary gap occurs when aggregate demand is less than the aggregate supply. These are two opposite situations. For instance, when inflation goes unchecked for some time, and prices reach a very high level, aggregate demand contracts and a slumpfollows. Private investment is discouraged. Inflationary and deflationary pressures exist simultaneously. The existence of an economic recession at the height of inflation is called ‘stagflation’. The effects of rising inflation and unemployment are especially hard to counteract for the government and the central bank. If monetary and fiscal measures are adopted to redress one problem, the other gets aggravated. Say, if a cheap money policy and public works programme are adopted to remedy unemployment, inflation gets aggravated. On the other hand, if a dear money policy and stringent fiscal measures are followed, unemployment gets aggravated. It is the most difficult type of inflation that the world is facing today. Keynesian remedial measures have notsucceeded in containing inflation but actually have aggravated unemployment. Thus, the world today stands between the devil (inflation) and deep sea (unemployment). Phillips curve A.W. Phillips, the British economist was the first to identify the inverse relationship between the rate of unemployment and the rate of increase in money wages. Phillips, in his empirical study, found that when unemployment was high, the rate of increase in money wage rates was low and when unemployment was low, the rate of increase in money wage rates was high. Phillips calls it the trade-off between unemployment and wages. This is illustrated in Figure 4. Unit 15: Inflation and Deflation 22 Managerial Economics Manipal University Jaipur (MUJ) Figure 4: Phillips Curve In the figure, the horizontal axis represents the rate of unemployment and the vertical axis represents the rate of wages. PC represents the Phillips curve; PC is sloping downwards and is convex to the origin of the two axes and cuts the horizontal axis. The convexity of PC shows that money wages fall with increase in the rate of unemployment or conversely, money wages rise with decrease in the rate of unemployment. This inverse relationship between wage rates and unemployment is based on the nature of business activity. During the period of rising businessactivity, the wage rate is high and the rate of unemployment is low and during periods of declining business activity, the wage rate is low and the rate of unemployment is high. Paul Samuelson and Robert Solow extended the Phillips curve analysis to the relationship between the rate of change in prices and the rate of unemployment and concluded that there is a trade-off between the level of unemployment in a country and the rate of inflation. We can use the same figure to illustrate this concept. Instead of wages, we show a rise in the price level on the OY axis. It will be clear from the figure that the higher the rate of inflation, lower is the rate of unemploymentin the country; and lower the rate of inflation, the higher the rate of unemployment in the country. It implies that one can be achieved at the costof the other. Phillips curve analysis can be a guide to the government in striking a balance between the measures to be adopted to solve the problem of unemployment and inflation. Unit 15: Inflation and Deflation 23 Managerial Economics Manipal University Jaipur (MUJ) 4. DEFLATION 4.1 Meaning Deflation is just the opposite of inflation. It is essentially a period of falling prices, fall in incomes, and rise in the value of money. Deflation is that state of the economy where the value of money is rising or the prices are falling. But every fall in price level is not deflation. Deflation is that state of falling prices which occurs at the time when output of goods and services increases more rapidly than the value of income in the economy. Deflation is a state of disequilibrium in which a contraction of purchasing power tends to cause or is the effect of a decline of price level. Thus, a fall in price level is both the result as well as the cause of the fall in money supply. 4.2 Effects of Deflation Deflation, like inflation, will have both dampening and encouraging effectson different sections of society. On production Deflation has an adverse effect on the level of production, business, and employment. Fall in demand and fall in prices force many firms to quit the industry or operate partially. Wages are reduced or workers are retrenched. It creates a hopeless situation in the area of production. On distribution Deflation adversely affects distribution of income too. In the first place, producers, merchants, and speculators badly lose during this period because prices of the goods fall at a much greater rate and faster than their costs. Being unable to cope with the situation, many are compelled toquit the industry. Failure of business and inability to repay the loans incurred with the banks worsen the position of the merchants and the producers. Debtors lose while the creditors gain. Fixed income groups enjoy a better standard of living because the income is fixed. There will be a rise in their real incomes. The salaried persons and wage earners will benefit from deflation. Unit 15: Inflation and Deflation 24 Managerial Economics Manipal University Jaipur (MUJ) However, the beneficial effects of deflation are far less compared to its adverse effects. During this period, because of unemployment, falling incomes, and output, a kind of pessimistic atmosphere is established in the entire economy. 4.3 Methods to Control Deflation Anti-deflationary measures are the opposite of those used to control inflation. Monetary policy – Central bank will have to follow a cheap moneypolicy – reducing the bank rate, organizing open market purchase of securities, reducing the margin requirements, etc. to encourage borrowing. But because of falling prices and low marginal efficiency of capital, cheap money policy of the central bank may not be very effective in controlling deflation. Fiscal policy – Fiscal measures like deficit financing, reduction in tax rates, tax concessions, public works programmes, may prove to be moreefficient in improving the situation than monetary measures. Other measures – Price support programmes, rationing of essential commodities, import of essential goods, grant of subsidies, developmentof infrastructure, marketing facilities, etc., may ease the situation tosome extent. Both inflation and deflation are dangerous. Of the two, deflation is more dangerous as it cripples the system and establishes a hopeless situationeverywhere. 8th Recession of 2008 ‘There was once a Great Depression’. This is what everybody would like to believe. The Depression of 1929 wreaked enormous damage across the world. In the United States of America, the government started the rebuilding exercise with President Roosevelt’s announcement of holiday for the banks for four days. The depression did end and the world moved at a greater pace and the third world countries were catching up on the ‘developed ones. Complacency was bound to step in. The rapidity and the magnitude of growth forced governments, corporate, and the top brass of institutions to look askance to the reckless manipulation of instruments of this growth during the early part of 21st century. Unit 15: Inflation and Deflation 25 Managerial Economics Manipal University Jaipur (MUJ) Starting August 2007, the world was in the grip of a financial whirlpool whichwas slowly but surely sucking in the hitherto unassailable giants of industry. The icons of the financial sector, Fannie Mae, Freddie Mac, which sound more like fast food chains, Lehman Brothers and the likes, were set to collapse like nine pins when the American government stepped in. The latter took upon itself a liability of $1 trillion. What triggered this collapse was a mix of highly complex financial instruments which the best brains werepaid hugely to develop and the false assumption that they could do no wrong. What kind of collapse did the above lead to?  The benchmark index of the Indian stock market, the SENSEX,came down from a high of 21000 to 8000 in less than a year.  Unemployment rates: In U.S.A, it went up from 4.9% (Jan-Mar 2008) to 6.8% (Oct-Dec 2008) In Japan, it declined to 3.7% (Oct-Dec 2008) from 3.8% (Jan-Mar 2008) In UK, it rose to 6.1% (Oct-Dec 2008) from 5.2% (Jan-Mar 2008)  The growth rate of National Income (GDP): In U.S.A, it came down to -6.4% (Oct-Dec 2008) from 0.9% (Jan-Mar2008) In Japan, it came down to -4.6% (Oct-Dec 2008) from 1.5% (Jan-Mar 2008) In UK, it came down to -1.8% (Oct-Dec 2008) from 2.6% (Jan-Mar 2008) In China, it came down to 6.8% (Oct-Dec 2008) from 10.6% (Jan-Mar 2008) In India, it came down to 7.8% (Apr-Jun 2008) and came down to 5.8% (Jan- Mar 2009)  The Stock Market Index: In U.S.A, Dow Jones index came down to 8,776 (Oct-Dec 2008) from 12,263 (Jan-Mar 2008) In Japan, it came down to 8,860 (Oct-Dec 2008) from 12,526 (Jan-Mar 2008) In UK, it came down to 4,434 (Oct-Dec 2008) from 5,702 (Jan-Mar2008) Unit 15: Inflation and Deflation 26 Managerial Economics Manipal University Jaipur (MUJ) In China, it came down to 1,943 (Oct-Dec 2008) from 3,784 (Jan-Mar 2008) In India, the SENSEX fell to 8,427 (Jan-Mar 2009) from 13,462 (Apr-Jun 2008)  Foreign Direct Investments (in US$ Bn.) and the growth rate ofFDI: In China, it came down to 18.0 (Oct-Dec 2008) from 27.4 (Jan-Mar 2008) while the FDI growth rate went down to -16.2% (Oct-Dec2008) from 61.3% (Jan-Mar 2008) In India, it declined to 6.2 (Jan-Mar 2009) from 10.1 (Apr-Jun 2008)while the growth rate of FDI was -48.1% (Jan-Mar 2009) from 101.4% (Apr-Jun 2008) What did the governments do to stabilize the economies? ▪ In U.S.A, the government announced fiscal stimulus packages worth about US$1.5 trillion. The Federal Reserve reduced different interest rates several times in the past six months. The Obama government advocated protectionist policies like Buy American goods, etc. ▪ In Japan, it led to quantitative easing by Bank of Japan under whichthe Central Bank increased the outright purchase of government bonds. Other measures included injecting liquidity through purchase ofcommercial papers, and short-term corporate bonds. ▪ In UK, protectionist policies were adopted apart from reducing differentinterest rates several times in the past six months to its present level of0.5%. BoE announced plans to ease quantitative easing. ▪ The People’s Bank of China, the Central Bank of China, affected five interest rate cuts in four months. The Central Bank also lowered the reserve requirement ratio for lenders by 0.5% to 13.5%. In November 2008, Chinese central government announced a 4 trillion Yuan economic stimulus package. In January 2009, FDI inflow was US$ 7.54 bn. The benchmark one-year lending and deposit rates were reduced by 0.27% to 5.31% and 2.25% respectively. ▪ Indian government announced three fiscal stimulus packages worth Rs. 70,000 crore (US$ 15bn.) between December 2008 and February 2009. These mainly included cut Unit 15: Inflation and Deflation 27 Managerial Economics Manipal University Jaipur (MUJ) in indirect taxes and higher market borrowings. The RBI reduced repo and reverse rates (rates at which the RBI lends to banks and absorbs liquidity respectively) five times since October 2008. Trade facilitation measures were announced to boost foreign trade. A survey by RBI indicated optimism from therespondents about the business scenario. (Source: Statistical Outline of India 2008-09 – TATA Services Ltd., Department of Economics and Statistics) Self-Assessment Questions – 1 1. The value of money and price level is related. 2. The state of steady rise in price level is called. 3. According to inflation is a phenomenon where too much money chases too few goods. 4. The inflationary situation where people go with basketful of money and come home with pocketful of commodities is. 5. The governments go for financing to finance public expenditure. 6. The concept of inflationary gap was introduced by. 7. The trade-off between inflation and unemployment is called the curve. 8. A situation where inflation is accompanied by stagnation is called. 9. A state of steady fall in price is called. 10. An increase in the overall level of prices in an economy is referred to aseconomic growth. (True/False) 11. Large or persistent inflation is almost always caused by excessivegrowth in the quantity of money. (True/False) 12. In the short run, falling inflation is associated with rising unemployment. (True/False) Unit 15: Inflation and Deflation 28 Managerial Economics Manipal University Jaipur (MUJ) Self-Assessment Questions – 1 13. If the price index in some country was falling over time, economists would say that the country had deflation. (True/False) 14. Deflation is negative inflation, not just a decrease in the inflation rate. (True/False) 15. Stagflation would result from the aggregate supply curve shifting to the left. (True/False) Unit 15: Inflation and Deflation 29 Managerial Economics Manipal University Jaipur (MUJ) 5. SUMMARY Let us recapitulate the important concepts discussed in this unit: Inflation refers to a general rise in price level. There are different typesof inflation like demand pull inflation, cost push inflation, etc. Inflation is caused by a number of factors like rise in the supply of money, increase in exports, black money, rise in the coast of production, hoarding, war, etc. It affects different sections of the population differently. Producers, merchants, and debtors gain while the consumers, laborers, and fixed income groups suffer. A number of measures like monetary, fiscal, and physical controls are adopted to control inflation. Inflationary gap is a Keynesian concept; it arises when the expenditureis in excess of the goods available in the economy. Phillips curve explains the inverse relationship that exists between the rate of unemployment and the rate of increase in wages. Paul Samuelson and Robert Solow using Phillips curve explain how at a higher rate of inflation, unemployment is low and how at a lower rate of inflation, the unemployment rate is high. It serves as a good guide to the government and the monetary authorities to adopt appropriate policiesto tackle the problem of unemployment and inflation. Deflation is a state of falling prices, incomes, output, and employment.As deflation has the danger of creating conditions of depression, it must be cured by adopting various monetary and fiscal measures. Unit 15: Inflation and Deflation 30 Managerial Economics Manipal University Jaipur (MUJ) 6. GLOSSARY Cost-push inflation: A situation wherein prices rise on account of the increasing cost of production. Deflation: State of the economy where the value of money is rising or prices are falling. Demand-pull Inflation: A situation where the total monetary demand persistently exceeds total supply of goods and services at current prices so that prices are pulled upwards by the continuous upward shift of the aggregate demand function. Inflation: A situation of substantial and rapid general increase in the level of prices and consequent deterioration in the value of money over a period of time. It refers to the average rise in the general level of prices and fall in the value of money. Inflationary gap: Amount by which aggregate expenditure would exceed aggregate output at the full employment level of income. Phillips curve: Indicates the inverse relationship between the rate of unemployment and the rate of increase in wages. Stagflation: A high rate of inflation combined with unemployment andeconomic recession. Unit 15: Inflation and Deflation 31 Managerial Economics Manipal University Jaipur (MUJ) 7. TERMINAL QUESTIONS 1. Discuss different kinds of inflation. 2. Explain the causes of inflation. 3. Describe the effects of inflation and the measures adopted to control it. 4. Explain the concept of inflationary gap. 5. Explain the effects of deflation and the methods adopted to control it. 8. ANSWERS Self - Assessment Questions 1. Inversely 2. Inflation 3. Coulborn 4. Jumping / galloping / hyper inflation 5. Deficit 6. Keynes 7. Philips 8. Stagflation 9. Deflation 10. False 11. True 12. True 13. True 14. True 15. True Terminal Questions 1. Depending upon the rate of rise in prices and the prevailing situation, inflation has been classified into six types. Refer to section 2. 2. Increase in aggregative effective demand is responsible for inflation Refer to section 2. 3. The positive effects of inflation are as many as social effects. Refer tosection 2. Unit 15: Inflation and Deflation 32 Managerial Economics Manipal University Jaipur (MUJ) 4. It is a gap between money incomes of the community and the availablesupply of output of goods and services. Refer to section 3. 5. Deflation, like inflation, will have both dampening and encouragingeffects on different sections of society. Refer to section 4 9. CASE STUDY A Price Balm for the Economy The annual wholesale price inflation rate fell to 6.55% in January, marking a fourth straight month of decline from the 10% high of September 2011. Much of it, which is probably in line with the Reserve Bank of India's (RBI) view, has to do with softening food prices from a bumper kharif harvest aided by good monsoon rains. Food inflation has, indeed, fallen far more spectacularly than the general inflation rate - from a level of 9.62% in September 2011 to -0.52% in January 2012. If this is more of a one-time phenomenon, it could be reversed if the next monsoon turns out to be bad (which some of the global weather models indicate). That, in addition to likely price increases of diesel and urea after the current state assembly elections, can reignite inflationary pressures all over again. This view has also been reinforced by the RBI's latest Inflation Expectations Survey of Households. It points to a higher proportion of respondents who believe that prices would rise by “more than the current rate” in the next three quarters, even while maintaining a more favourable outlook for January-March 2012. In other words, the inflation expectations beyond the near-term continue to be high. The above view may not be wrong. One cannot rule out inflation returning, which then explains the RBI's obvious reluctance to ease its hard money stance. But the issue right now is about identifying the main problem confronting the Indian economy. That perhaps is not inflation as much as the virtual drying up of investments. One may even go further to argue that the variable really worth monitoring today – more than the wholesale price index – is the capital goods production index. That has registered negative year-on-year growth for four consecutive months from September to December, indicative of hardly any new orders for plant and equipment being placed by companies. It has implications for not only future growth, but even inflation, which Unit 15: Inflation and Deflation 33 Managerial Economics Manipal University Jaipur (MUJ) requires a durable cure that can come only from augmenting supply. In the event of no extra productive capacities being created, any revival in demand only increases the chances of prices going up. It is all the more necessary, then, not to have policies that in the name of fighting inflation actually endup stifling supply response. That being the case, the right policy to be adopted in the present circumstances is one of fiscal consolidation, redirecting government expenditures away from consumption to investment. This, in combination with the much-needed lowering of interest rates and credible measures signalling the government's commitment to reforms, would put an end to the current ‘famine' as far as green field projects are concerned. A revival of investment may ultimately have a benign impact on prices as well. (Source: An article of the same title that was published in the Hindu Business Line dated February 15, 2012) Discussion Questions: 1. What is the relationship between fiscal policy and inflation? 2. How does inflation influence investments? Hint: Use the theoretical concept and answer the questions Unit 15: Inflation and Deflation 34 Managerial Economics Manipal University Jaipur (MUJ) 10. REFERENCES Spencer, Milton H. & Siegelman, Louis (1959), Managerial Economics, Homewood, Illinois: Richard. D. Irwin, Inc., McNair, Malcolm P. & Meriam, Richard S., (1941), Problems in Business Economics, New York & London: McGraw Hill Book Co. Inc., Pappas, James L., & Brigham, Eugene F., (1979), Managerial Economics, Hinsdale: Ill Dryden Press. Dean Joel, (1951), Managerial Economics, Englewood Cliffs: NJ, Prentice Hall. the Hindu Business Line dated February 15, 2012) E-References www.thehindubusinessline.com Unit 15: Inflation and Deflation 35 Managerial Economics Manipal University Jaipur (MUJ) MASTER OF BUSINESS ADMINISTRATION SEMESTER 1 MANAGERIAL ECONOMICS Unit 14: Exchange Rate and Balance of Payment (BOP) 1 Managerial Economics Manipal University Jaipur (MUJ) Unit 14 Exchange Rate and Balance of Payment (BOP) Table of Contents Fig No / SAQ / Page SL.No Topic Table / Activity No Graph 1 Introduction - - 3-4 1.1 Objectives - - 2 Exchange Rate - Meaning and types of rates 1 1 5 – 10 2.1 Determinants of exchange rate - 2 3 Meaning and overview of Balance of Payment - 3.1 Meaning - 3 3.2 Overview of Balance of Payment i 4 11 – 20 3.3 Components of Balance of Payment ii, iii, iv 5 Disequilibrium in Balance of Payment – Causes 3.4 - 6 and its corrections. 4 Summary - - 21 - 22 5 Glossary - - 23 - 24 6 Terminal Questions - - 25 7 Answers - - 26 – 28 8 References - - 29 Unit 14: Exchange Rate and Balance of Payment (BOP) 2 Managerial Economics Manipal University Jaipur (MUJ) 1. INTRODUCTION In the previous unit we studied Business Cycle – its Meaning and Features, Theories of Business Cycles, Measures to Control Business Cycles, Business Cycles and Business Decisions. The way a manager needs to understand microeconomic and macroeconomic concepts in the same manner he needs to know about international business. Specially, the knowledge of foreign exchange and balance of payment, as both these concepts helps in exporting and importing materials for any business entity. In the study of international economics, exchange rates and the balance of payment are essential ideas because they are crucial to understand the dynamics of global trade, finance, and economic stability. The foreign exchange market is merely a part of the money market in the financial centers. It is a place where foreign sums of money are bought and sold. The value of a currency compared to that of another nation is referred to as its exchange rate. Due to their ability to affect international commerce and investment pricing for products and services, they are essential. Depending on a nation's monetary policies, exchange rates may be fixed or flexible. On the other hand, trade flow is the act of purchasing and selling goods and services between countries. We can say that trade flow is the flow of imports and exports. It measures the balance of trade. The country imposes restrictions that are tariff and non-tariff restrictions. Man-made trade barriers are tariffs, import license, export license, subsidies, trade restrictions, non-tariff barriers to trade, import quotas, currency devaluation, voluntary export restraints. In the current unit we will understand that why the balance of payments and foreign exchange rates is essential for making informed economic decisions, managing risks, and promoting overall economic stability and growth in a globalized world. 1.1. Objectives Learning objectives are to: ❖ Explain meaning of foreign exchange. ❖ Analyze various types of exchange rates. ❖ Understand the concept of Balance of Payment and its implications. Unit 14: Exchange Rate and Balance of Payment (BOP) 3 Managerial Economics Manipal University Jaipur (MUJ) ❖ Assess the components of the balance of payment. ❖ Explore the ways to correct disequilibrium in balance of payment. Unit 14: Exchange Rate and Balance of Payment (BOP) 4 Managerial Economics Manipal University Jaipur (MUJ) 2. EXCHANGE RATE - MEANING AND TYPES The collection of guidelines determining how a nation's currency is valued in respect to other currencies is referred to as its exchange rate system, or exchange rate regime. Exchange rate systems are adopted by different countries according to their economic strategies, objectives, and preferences. Exchange rate systems come in a variety of forms and can be broadly classified as fixed, floating, or managed. A financial institution of a nation or a financial union controls funds in connection to other currencies and the foreign exchange market using an exchange rate regime. It closely resembles monetary policy and is frequently dependent on numerous comparable elements, including the state of the economy, its openness, inflation, the stability of the labor market, the growth of the financial sector, and cash. It normally falls into three categories; these categories are as follows: Fig 1: Types of Exchange Rate Regimes Source: Self Compiled When currency rates are set solely by market forces and often used by the open market, they are said to be floating, or flexible, exchange rates. Though government of a Country may influence exchange rate through foreign trade agreements, interest rate changes, and stock purchases and sales. Exchange rate regimes that are fixed, often known as pegged, occur when a nation establishes its own currency based on the value of another currency or asset. Earlier countries used to follow gold as a standard to fix their currency now a days they are fixed (concrete) in floating currencies from major countries. Many countries place their currency in US dollars, the Euro, or the British Pound. Unit 14: Exchange Rate and Balance of Payment (BOP) 5 Managerial Economics Manipal University Jaipur (MUJ) A managed floating exchange rate regime, also referred to as a "dirty float," is one in which the exchange rate is neither entirely fixed nor free or float. Instead, through the involvement of the central bank, the value of the currency is maintained within a range relative to another currency or a basket of currencies. There are also exchange rate regimes that include the properties of other states. This division of state exchange rate is based on the classification approach developed by GGOW (Ghos, Guide, Ostry and Wolf, 1995, 1997), which incorporates IMF de jure segregation and actual exchange behaviour to distinguish between legal and real policies. The GGOW classification method is also called the Trichotomy Method. There are many factors a country needs to consider before deciding on a fixed or floating currency, with both pros and cons. If a country chooses to adjust its currency to the United States Dollar they gain exchange rate stability. This means that whenever you trade with the U.S. It will always be certain how much their money will be worth according to the American Dollar. Hong Kong has deployed its currency in US dollars at an almost 8 to 1 rate. Each U.S. dollar will always cost about $ 8 in Hong Kong unless it changes its empire. Businesses love this guarantee and barking your money can lead to foreign direct investment (FDI). Unfortunately, when a country decides to adjust their finances, they lost financial independence. They cannot set their exchange rates and the strength/weakness of their currency depends entirely on the money they have prepared for themselves If a country chooses to float freely, like the US dollar, they are financially independent but loses the strength of the exchange rate with a fixed currency. Note that you are not only able to achieve financial independence but also the strength of the exchange rate. This failure to have both is part of a concept known as the incompatible Trinity. When deciding on monetary policy countries can achieve two-thirds of the things. Complete financial consolidation, exchange rate stability, or financial independence. The country will never have enough money to cover all three. 1. Floating Exchange Rate Regimes: The floating exchange rate is the state in which the price of the national currency is set by the forex market according to the provision and demand associated with other currencies. This is compared to a fixed exchange rate, which Unit 14: Exchange Rate and Balance of Payment (BOP) 6 Managerial Economics Manipal University Jaipur (MUJ) the government determines in whole or in part. Floating exchange rates mean a long-term exchange rate change reflects the economic potential associated with interest rates variations between countries. The short-term movement in the floating exchange rate reflects speculation, rumours, disasters, and daily supply and demand. If the amount of the offer demands that amount it will decrease, and if the amount required to supply that amount will increase. Excessive temporary measures can lead to interventions by major banks, or in a floating area. As a result, while large global currencies are considered floating, central banks and governments can step in if the national currency becomes too high or too low. Too much or too little money can adversely affect the country's economy, affect trade and pay off debts. The government or the central bank will try to use the means to transfer their money at a reasonable price. 2. Fixed Exchange Rate Regimes: A fixed exchange rate is a state-owned state or central bank that combines the exchange rate of a country with gold. The purpose of a fixed exchange system is to keep the amount of money within the minimum wage. Scheduled ratings offer great assurance to both importers and exporters. Prices are set and help the government maintain a lower inflation rate, which in turn, keeps prices low and promotes trade and investment. Many large developed countries have floating exchanges, where the price of moving to the foreign exchange market (forex) sets its value for money. The practice began in these nations in the early 1970s while the developing economy continued with programs with steady standards. Currency rates can be determined in two ways: float rate or fixed rate. As mentioned above, the floating rate is usually determined by the open market by supply and demand. Therefore, if the demand for money is high, the value will increase. If demand is low, this will drive that price down. The fixed-rate or peg is determined by the government through its central bank. The rate is set for another major world currency (such as the US dollar, euro, or yen). To maintain its exchange rate, the government will buy and sell its currency compared to its targeted Unit 14: Exchange Rate and Balance of Payment (BOP) 7 Managerial Economics Manipal University Jaipur (MUJ) currency. Other countries that choose to invest in the U.S. dollar include China and Saudi Arabia. The world's largest economies were allowed to float freely following the collapse of the Bretton Woods program between 1968 and 1973. 3. Managed Exchange rate regime: An exchange rate control policy in which the government allows the exchange rate to adjust to equilibrium levels through the interaction of supply and demand in the foreign exchange market, but intervenes on occasion. The majority of countries around the world now employ a managed flexible exchange rate policy, often known as crawling pegged, mixed, fixed floating, or dirty float. An exchange rate is free to grow and fall in this alternative, but it is subject to government regulation if it rises too high or too low. With managed float, the government enters the foreign exchange market and buys or sells whatever currency is required to keep the exchange rate within predetermined boundaries. A managed flexible exchange rate is a hybrid of fixed and flexible exchange rate policies. It recognizes the advantages of a flexible exchange rate that adjusts to equilibrium automatically in response to fluctuations in the foreign exchange market. It also acknowledges that the resulting currency rate may not always produce desired international trade patterns and that the government may need to intervene to temporarily fix the rate. SELF-ASSESSMENT QUESTIONS – 1 1. How a financial institution of a country or a financial union manages money concerning other currencies and the foreign exchange market is: a. An exchange rate regime b. Aggregate demand c. Business process outsourcing (BPO) d. Franchising 2. The ________________ is the state in which the price of the national currency is set by the forex market according to the provision and demand associated with other currencies. 3. _________________ is a state-owned state or central bank that combines the exchange rate of a country with gold. Unit 4. 14:The fixed-rate Exchange Rateor peg and is determined Balance by(BOP) of Payment the government through its central bank. 8 [True/ False] Managerial Economics Manipal University Jaipur (MUJ) 4. The fixed-rate or peg is determined by the government through its central bank. [True/ False] 5. If a country chooses to float freely, like the US dollar, they are financially independent but loses the strength of the exchange rate with a fixed currency. [True/ False] 2.1. Determinants of Exchange Rate Many factors affect exchange rates, or the value of one currency in relation to another. These factors can be broadly divided into the following grops: Interest Rates: A nation's currency will appreciate if its interest rates are higher because this will draw in foreign money looking for higher returns. Inflation Rates: Lower inflation rates in a country are generally associated with an appreciation of its currency because it increases purchasing power. Trade Balance: The difference between imports and exports, or a nation's trade balance, can affect its currency. Currency depreciation can result from a trade deficit, and currency appreciation might arise from a trade surplus (more exports than imports). Central bank: Central banks buy and sell foreign currency this may affect domestic currency prices. These interventions aim to achieve various objectives, such as stabilizing the currency, promoting export competitiveness, or addressing excessive volatility. Open Market operations: The money supply and interest rates are impacted by central banks' open market purchases and sales of government assets. A central bank can cut short-term interest rates by injecting money into the banking system through the purchase of government assets. This has the ability to boost economic growth and cause the value of the national currency to decline as investors look abroad for more lucrative opportunities. On the other hand, selling assets draws funds out of the system, which could lead to an increase in interest rates and a possible strengthening of the currency. Economic indicators: Exchange rates can be affected by a range of economic factors, including GDP growth, employment rates, and manufacturing production. A nation's currency often appreciates in value when its economy is doing well. Other factors such as political and economic development of a country and government debts also plays a crucial role in deciding foreign currency value. Unit 14: Exchange Rate and Balance of Payment (BOP) 9 Managerial Economics Manipal University Jaipur (MUJ) SELF-ASSESSMENT QUESTIONS – 2 6. ____________rates in a country are generally associated with an appreciation of its currency because it increases purchasing power. a. Exchange rate b. Inflation c. Tax d. Interest 7. Devaluation in domestic currency may _________exports. a. Increase b. Decrease c. No effect 8. Trade deficit can lead to ________. a. Currency devaluation b. Currency appreciation Unit 14: Exchange Rate and Balance of Payment (BOP) 10 Managerial Economics Manipal University Jaipur (MUJ) 3. MEANING AND OVERVIEW OF BALANCE OF PAYMENT 3.1. Meaning A nation has to communicate with other countries on the following: 1. Visible goods, which includes every kind of physically imported and exported goods. 2. Invisible items, which includes all services with covert import and export. for instance, transportation and healthcare services. 3. Capital transfers, which deal with capital payments and receives. Balance Of Payment is a statement which records all the monetary transactions made between residents of a country and the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporates and the government and helps in monitoring the flow of funds to develop the economy. When all the elements are correctly included in the BOP, it should sum up to zero in a perfect scenario. This means the inflows and outflows of funds should balance out. However, this does not ideally happen in most cases. BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e when a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, BOP deficit indicates that a country’s imports are more than its exports. Tracking the transactions under BOP is something similar to the double entry system of accounting. This means, all the transaction will have a debit entry and a corresponding credit entry. Balance Of Payment : Definition As per Reserve Bank of India - The balance of payments of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world. It presents a classified record of all receipts on account of goods exported, services rendered and capital received by residents and payments made by them on account of goods imported and services received from the capital transferred to non-residents or foreigners. Unit 14: Exchange Rate and Balance of Payment (BOP) 11 Managerial Economics Manipal University Jaipur (MUJ) According to Kindle Berger, "The balance of payments of a country is a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries during a given period of time". It is a double entry system of record of all economic transactions between the residents of the country and the rest of the world carried out in a specific period of time when we say “a country’s balance of payments” we are referring to the transactions of its citizens and government. SELF-ASSESSMENT QUESTIONS – 3 Fill in the blanks 9. When a country’s export is more than its import, its BOP is said to be in ______. 10. ______________of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world. 3.2. Overview of Balance of Payment Overview of Balance of payment may include its features, importance, and its differences from Balance of trade. Let us discuss first the Balance of trade to understand its difference from Balance of Payment. Balance of trade – Balance of trade is a largest component or part of the balance of payment. All the trade transactions with the rest of the world are known as balance of trade. Generally, it is the difference between the imports and exports of a country. When exports are greater than imports than the BOT is favourable and if imports are greater than exports then it is unfavourable. Table 14.1 Difference between Balance of Payment and Balance of trade Balance of Payment Balance of Trade It is a broad term as it includes all the It is a narrow term as it includes all the trade transactions of a country with the rest of the of the visible items. world. BOP = Current Account + Capital Account + BOT = Net Earning on Export - Net payment or - Balancing item (Errors and omissions) for imports. Unit 14: Exchange Rate and Balance of Payment (BOP) 12 Managerial Economics Manipal University Jaipur (MUJ) Balance of payment tries to balances itself It can be favourable or unfavourable Factors which affect BOP are - Conditions of Factors which affect Balance of trade are - foreign lenders, Economic policy of Govt. cost of production, availability of raw materials, Exchange rate, Prices of goods manufactured at home Source: Self compiled Features of Balance of Payment - It is a systematic record of all economic transactions between one country and the rest of the world. It includes all transactions, visible as well as invisible. It relates to a period of time. Generally, it is an annual statement. It adopts a double-entry book-keeping system. It has two sides: credit side and debit side. Receipts are recorded on the credit side and payments on the debit side. Importance of Balance of Payment – 1. BOP records all the transactions that create demand for and supply of a currency. 2. Judge economic and financial status of a country in the short-term 3. BOP may confirm trend in economy’s international trade and exchange rate of the currency. This may also indicate change or reversal in the trend. 4. This may indicate policy shift of the monetary authority (RBI) of the country. 5. BOP may confirm trend in economy’s international trade and exchange rate of the currency. This may also indicate change or reversal in the trend. SELF-ASSESSMENT QUESTIONS – 4 11. ___= Current Account + Capital Account + or - Balancing item (Errors and omissions) a. BOP b. BOT c. Surplus d. Deficit 12. BOP and BOT are same. [True/False] Unit 14: Exchange Rate and Balance of Payment (BOP) 13 Managerial Economics Manipal University Jaipur (MUJ) 3.3. Component of Balance of Payment There are following components of Balance of Payment: 1. Current Account – Further the main components of Current Account are - i. Export and Import of Goods (Merchandise Transactions or Visible Trade): A major part of transactions in foreign trade is in the form of export and import of goods (visible items). Payment for import of goods is written on the negative side (debit items) and receipt from exports is shown on the positive side (credit items). Balance of these visible exports and imports is known as balance of trade (or trade balance). ii. Export and Import of Services (Invisible Trade): It includes a large variety of non- factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services. Services are generally of three kinds: (a) Shipping, (b) Banking, and (c) Insurance. Payments for these services are recorded on the negative side and receipts on the positive side. iii. Unilateral or Unrequited Transfers to and from abroad (One sided ransactions): Unilateral transfers include gifts, donations, personal remittances and other ‘one-way’ transactions. These refer to those receipts and payments, which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side. iv. Income receipts and payments to and from abroad: It includes investment income in the form of interest, rent and profits. Balance on Current Account: In the current account, receipts from export of goods, services and unilateral receipts are entered as credit or positive items and payments for import of goods, services and Unit 14: Exchange Rate and Balance of Payment (BOP) 14 Managerial Economics Manipal University Jaipur (MUJ) unilateral payments are entered as debit or negative items. The net value of credit and debit balances is the balance on current account. 1. Surplus in current account arises when credit items are more than debit items. It indicates net inflow of foreign exchange. 2. Deficit in current account arises when debit items are more than credit items. It indicates net outflow of foreign exchange. Table 14.2 Balance of current account 2. Capital Account Capital account of BOP records all those transactions, between the residents of a country and the rest of the world, which cause a change in the assets or liabilities of the residents of the country or its government. It is related to claims and liabilities of financial nature. Capital Account is used to: (i) Finance deficit in current account; or (ii) Absorb surplus of current account. Unit 14: Exchange Rate and Balance of Payment (BOP) 15 Managerial Economics Manipal University Jaipur (MUJ) Capital account is concerned with financial transfers. So, it does not have direct effect on income, output and employment of the country. Following are the components of capital account- 1. Borrowings and lendings to and from abroad: It includes: A. All transactions relating to borrowings from abroad by private sector, government, etc. Receipts of such loans and repayment of loans by foreigners are recorded on the positive (credit) side. B. All transactions of lending to abroad by private sector and government. Lending abroad and repayment of loans to abroad is recorded as negative or debit item. 2. Investments to and from abroad: It includes: A. Investments by rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange. B. Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments to abroad be recorded on the negative (debit) side as they lead to outflow of foreign exchange. 3. Change in Foreign Exchange Reserves: The foreign exchange reserves are the financial assets of the government held in the central bank. A change in reserves serves as the financing item in India’s BOP. So, any withdrawal from the reserves is recorded on the positive (credit) side and any addition to these reserves is recorded on the negative (debit) side. It must be noted that ‘change in reserves’ is recorded in the BOP account and not ‘reserves’. Balance on Capital Account: The transactions, which lead to inflow of foreign exchange (like receipt of loan from abroad, sale of assets or shares in foreign countries, etc.), are recorded on the credit or positive side of capital account. Similarly, transactions, which lead to outflow of foreign exchange (like repayment of loans, purchase of assets or shares in foreign countries, etc.), are recorded on the debit or negative side. The net value of credit and debit balances is the balance on capital. Unit 14: Exchange Rate and Balance of Payment (BOP) 16 Managerial Economics Manipal University Jaipur (MUJ) A. Surplus in capital account arises when credit items are more than debit items. It indicates net inflow of capital. B. Deficit in capital account arises when debit items are more than credit items. It indicates net outflow of capital. In addition to current account and capital account, there is one more element in BOP, known as ‘Errors and Omissions’. It is the balancing item, which reflects the inability to record all international transactions accurately. Table 14.3 Balance of capital account Table 14.4 Balance of Payment Unit 14: Exchange Rate and Balance of Payment (BOP) 17 Managerial Economics Manipal University Jaipur (MUJ) Source: Self Compiled SELF-ASSESSMENT QUESTIONS – 5 13. ___________is an example of invisible trade. a. Shipping b. Textile c. Jute d. Iron 14. ___________transfers include gifts, donations, personal remittances and other ‘one-way’ transactions. a. Bilateral b. Dual c Unilateral d. Complete Unit 14: Exchange Rate and Balance of Payment (BOP) 18 Managerial Economics Manipal University Jaipur (MUJ) 3.4. Disequilibrium in Balance of Payment – Causes and its corrections A disequilibrium in the balance of payment means its condition of Surplus Or deficit. A Surplus in the BOP occurs when Total Receipts exceeds Total Payments. A Deficit in the BOP occurs when Total Payments exceeds Total Receipts. There are several factors that can contribute to disequilibrium in the balance of payments: Trade imbalance – Trade deficit where imports are more than export, trade surplus where exports are more than imports. Currency fluctuations - A nation's balance of payments may be affected by abrupt and large fluctuations in the value of its currency. A strong domestic currency may increase the cost of exports while lowering the cost of imports, resulting in a trade deficit. Economic Development Rapid increase in population Structural Changes Natural Calamites Following are the measures to correct disequilibrium in Balance of Payment – ❖ Monetary Measures Monetary Policy The monetary policy is concerned with money supply and credit in the economy. The Central Bank may expand or contract the money supply in the economy through appropriate measures which will affect the prices. Fiscal Policy Fiscal policy is government's policy on income and expenditure. Government incurs development and non - development expenditure. It gets income through taxation and non - tax sources. Depending upon the situation governments expenditure may be increased or decreased Exchange Rate devaluation By reducing the value of the domestic currency, government can correct the disequilibrium in the BoP in the economy. Exchange rate depreciation reduces the Unit 14: Exchange Rate and Balance of Payment (BOP) 19 Managerial Economics Manipal University Jaipur (MUJ) value of home currency in relation to foreign currency. As a result, import becomes costlier and export become cheaper. Devaluation Devaluation is lowering the exchange value of the official currency. When a country devalues its currency, exports become cheaper and imports bec