Money Supply and Inflation

MONEY SUPPLY

Stock of money in circulation in the economy at a given point of time. It is partially exogenous (decided by the government and the central bank) and partially endogenous.

Measure of Money Supply

A. Narrow Money (M1) – Currency with the public + Demand deposits with the banking system + Other deposits with the RBI

B. M2 – M1 + Saving deposits of post office saving banks

C. M3 – M1 + Time deposits with the banking systems

D. M4 – M3 + All deposits with the post office saving banks (excluding NSC )

Note –

Currency with the public – Currency in circulation less cash held by bank

Demand Deposit – Payable on demand

Time Deposit – Payable other than on demand

INFLATION

Ø  Sustained rise in the general level of prices of goods and services in an economy over a period of time.

Ø  Negative effects of inflation include loss in stability in the real value of money and other monetary item over time.

Ø  Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt.

CAUSE OF INFLATION

1. Demand-pull Inflation

Rise in general prices caused by increasing aggregate demand for goods and services

Demand exceed s supply → Shortage → an increase in prices

2. Cost-Pull Inflation

Substantial increase in the cost of production of important goods or services where no suitable alternative is available.

Inflation = (Price Index in current year – Prices index in Base year) * 100

PRICE INDEX

A price index is a weighted average of the prices of a selected basket of goods and services relative to their prices in some designated base-year.

Most important price indexes are –

1. Wholesale Price Index (WPI)

Reflect the change in the level of prices of a basket of goods at the wholesale level and will be announced by government monthly.

2. Food inflation index (FII)

Announced weekly

3. Consumer Price Index (CPI)

Ø  Change in the level of prices purchased / consumed by the households.

Ø  It is the cost of living index popularly known as Core Inflation

Ø  CPI in India released by Labour Bureau, Ministry of Labour and Employment, Govt. of India

4. GDP Deflator

Measure of the level of prices of all new, domestically produced, final goods and services in an economy.