Control of Inflation

Economists agree that inflation beyond a moderate rate is undesirable as it can often prove disastrous and therefore, it must be kept under control. Economists agree also that an appropriate mix of fiscal and monetary policies can be helpful in controlling inflation. However, there is divergence of opinion on the effectiveness and primacy of fiscal and monetary policies in the policy mix. While monetarists argue that monetary measures should be given prime role in the antiinflationary policy-mix, fiscalists argue, on the contrary, that fiscal policy is more effective in controlling inflation. Besides, even the very issue of controlling inflation poses a dilemma because controlling inflation involves the risk of accentuating the problem of unemployment. Several measures to control inflation have been devised and suggested in addition to fiscal and monetary policies. In nutshell, measures which have been suggested in addition to fiscal and monetary policies. In nutshell, measures to control inflation remain a controversial issue. Nevertheless, we will discuss here, the various measures which have been suggested by the economists and are used by the governments of different countries from time to time.

Traditional monetary measures

The traditional monetary measures used to control inflation include:

(a) Bank rate policy

(b) Variable reserve ration or cash reserve ratio (CRR)

(c) Open market operation

Bank rate policy: bank rate or, more appropriately, central bank rediscount rate is the rate at which central bank buys or rediscounts the eligible bills of exchange and other approved commercial papers presented by the commercial banks. The central bank performs this function as the lender of the last resort. In India, where the bill market is underdeveloped, the bank advances money to the commercial banks in two forms: (i) in the form of advances mostly against the government securities, and (ii) rediscounting facility for eligible usance bills and other approved securities. The bank rate policy is used during the period of inflation as a central instrument of monetary control/ the bank rate forms the basis of lending rate charged by the banks. When the central bank raises that bank rate, it is said to have adopted a dear money policy and when it reduces the bank rate, it cheap money policy. The bank rate as a measure of monetary control works in two ways.

One, where objective is to control inflation, the central bank raises the bank rate. This increases the cost of borrowing and, therefore, reduces banks' borrowing from the central bank, the lower borrowing by the banks to the public reduces their ability to create credit. As a result, flow of money from the commercial banks to the public reduces. Therefore, price is halted to the extent it is reduced by the credit money. 

Variable reserve ratio: 
commercial banks are required to maintain a certain proportion of their demand and time deposits in the form of cash reserves. A part of this reserve is maintained as cash in hand for meeting their day-to-day payment requirements and a part is maintained with the central bank as statutory reserves. The statutory reserve requirement called cash reserve ratio is determined and imposed by the central bank. The CRR has been changing in India. The central bank uses the CRR as a weapon to control money supply. With an objective to controlling inflation, the central bank raises the CRR. Increasing CRR is virtually with drawl of money from the circulation. In effect, when a central bank raises the CRR, to reduce the lending capacity of the commercial banks. As a result, flow of money from commercial banks to the public decreases. This halts the rise in prices to the extent it is caused by the bank creditors. This method of controlling inflation has the same limitations as the bank rate policy. 

The RBI adopted the same approach when inflation rate turned to be negative in mid-2009. It cut down the repo rate by 0.5 percentage point.

Open market operations: open market operation refers to sale and purchase of the government securities and debts by the central bank to and from the public. This function is performed by the central bank as government's banker. Where objective is to control inflation through monetary policy, the central bank sells the government securities to the public through the authorized commercial banks. By selling the government securities in the open market, the central bank make money to flow from the public to the central bank. When people use their bank deposits to buy government bonds, it reduces the deposits available to the banks for lending.

Non-traditional measures

Statutory liquidity ratio (SLR): the statutory liquidity ratio (SLR) is one of the non-traditional method of monetary of the monetary control used by in addition to the cash reserve ratio. The objective of this is to allocate the total bank credit between the government and the business sector. The SLR is a double-edged weapon. On the one hand, it controls the central government borrowings from the RBI, and on the other, it restricts the freedom of the banks to sell the government securities or to borrow against them for the RBI. Under this method of monetary control, banks are required by the statue to maintain a certain minimum proportion of their daily demand and time liabilities (DTL) in the form of certain designated liquid assets.

   Related Questions in Macroeconomics

©TutorsGlobe All rights reserved 2022-2023.