UNIT IV - Money Supply and Price Level

Measures of money supply

Creation of Credit/ money in the economy

Inflation- causes and remedies

Deflation - causes and remedies

Money Supply
If money supply is to be monitored and controlled we need to measure it. We find a close
relationship between money supply, growth, and inflation. Monetary policy aims at
controlling the stock of money so that the problem of inflation or deflation can be avoided.
Before explaining the relationship between money supply growth and the rate of inflation, we
must know exactly what money supply is
The money supply is the total amount of assets in
circulation which are acceptable in exchange for
goods. In modern economies people accept either
notes and coins or an increase in their current
account as payment. Hence the money supply is
made up of cash and bank deposits. There are five
main measures of the money supply known as M0
to M4.
Usually, there are two measures of the money
supply—narrow money supply, and broad money supply. This is because of the
differences in the nature of deposits of banks.
Reserve Money (M0): It is also known as High-Powered Money, monetary base, base
money etc.
M0 = Currency in Circulation + Bankers’ Deposits with RBI + Other deposits with RBI
It is the monetary base of economy
Narrow money supply is called
M1. It consists of notes and coins in circulation and demand deposits with banks and central
bank. This narrowest measure of money supply has the attribute of greatest liquidity in the
sense that this kind of money supply can be quickly and easily used for transactions. This
may be called transactions money.
M2 consists of M1 plus other deposits (savings deposits). These deposits are indeed liquid
but not quite as liquid as demand deposits included in M1. These deposits are not
immediately available for spending. After a certain lapse of time, these deposits could be
utilized for purchasing goods and services.

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Broad money supply, M3, M1 + Time Deposits
However, there are some differences in the definitions of money supply from country to
country. In view of this, we find disagree-ments about whether M1 (narrowly-defined) or M2
(broadly-defined) or something else is the best definition of money supply.
In this connection, we may refer the RBI’s four measures of money supply—M1, M2, M3,
and M4:
• Reserve Money (M0): It is also known as High-Powered Money, monetary base,
base money etc.
M0 = Currency in Circulation + Bankers’ Deposits with RBI + Other deposits with
RBI
It is the monetary base of economy.
• Narrow Money (M1):
M1 = Currency with public + Demand deposits with the Banking system (current
account, saving account) + Other deposits with RBI
M2 = M1 + Savings deposits of post office savings banks
• Broad Money (M3)
M3 = M1 + Time deposits with the banking system
• M4 = M3 + All deposits with post office savings banks

Liquidity of these Measures of Money Supply

• The liquidity means how fast an instrument can be converted into cash. The liquidity
of these measures are in order M1>M2>M3>M4 i.e. M1 is most liquid and M4 is least
Reserve Money (M0): It is also known as High-Powered Money, monetary base, base money
etc.
• M0 = Currency in Circulation + Bankers’ Deposits with RBI + Other deposits with
RBI
It is the monetary base of economy.
• Narrow Money (M1):
• M1 = Currency with public + Demand deposits with the Banking system
(current account, saving account) + Other deposits with RBI
• M2 = M1 + Savings deposits of post office savings banks
• Broad Money (M3)
• M3 = M1 + Time deposits with the banking system
• M4 = M3 + All deposits with post office savings banks

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 • Of all these, M1 is considered as the most important measure of money. M1includes
virtually all the money supplied by the RBI, the Government of India, and the
commercial banks.

MONEY CREATION/DEPOSIT CREATION/CREDIT CREATION BY

COMMERCIAL
Issuing Currency and role of BANKS
There are two ways if increasing the money supply in any economy. The first method is
through the printing of more currency notes. However as we know the issuing of money
supply is solely restricted to the function of central banks of every country. No other
commercial banks or financial institutions have the ability or the liberty to print notes as per
their choice. As we know uncontrolled and unmonitored printing of notes can directly impact
and cripple the economic growth of any economy as a result of the inflationary trends that
associate closely with respect to it. Therefore method is used only after deliberations wr.t
central bank and government after due consideration on the state of the economy.
Another way in creation of money or credit in the economy is with respect to the commercial
banks.
The lending ability of the commercial leads to increasing investment activities in the
economy that leads to increase in money supply in an economy.
Let us understand the process of credit creation with the following example.
Suppose there is an initial deposit of Rs. 100,000 and C.R.R. is 20% i.e., the banks have to
keep Rs. 20000 and lend Rs. 80000/-. All the transactions are routed through banks. The
borrower withdraws his Rs. 80000/- for making payments which are routed through banks in
the form of deposits account. The Bank receives Rs. 80000/- as deposit and keeps 20% of
Rs.800/- i.e., Rs.16000/- and lends Rs.64000/- . Again the borrower uses this for payment
which flows back into the banks thereby increasing the flow of deposits.

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This process helps us understand how deposits in bank help in creation of money in the
economy.
MONEY MULTIPLIER plays a very important role in the determination of how much
money supply is created

The Money Multiplier refers to how an initial deposit can lead to a bigger final increase in
the total money supply.
For example, if the commercial banks gain deposits of £1 million and this leads to a final
money supply of £10 million. The money multiplier is 10.

The money multiplier is a key element of the fractional banking system.

1. There is an initial increase in bank deposits (monetary base)

2. The bank holds a fraction of this deposit in reserves and then lends out the rest.
3. This bank loan will, in turn, be re-deposited in banks allowing a further increase in
bank lending and a further increase in the money supply.
The Reserve Ratio
The reserve ratio is the % of deposits that banks keep in liquid reserves.

For example 10% or 20%

Formula for money multiplier

Money Multiplier = 1/Reserve Ratio.

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In the above example RR is 20% i.e., 0.2, so money multiplier is equal to 1/0.2=5.

Extra Info (not for exam) what "backs" the money supply?
The government's ability to keep its value stable provides the backing. Money is debt; paper
money is a debt of Central Banks and checkable deposits are liabilities of banks and thrifts
because depositors own them.
Value of money arises not from its intrinsic value, but its value in exchange for goods and
services.
It is acceptable as a medium of exchange.
Currency is legal tender or fiat money. It must be accepted by law. The relative scarcity of
money compared to goods and services will allow money to retain its purchasing power.
Money's purchasing power determines its value. Higher prices mean less purchasing power.
Excessive inflation may make money worthless and unacceptable. An extreme example of
this was German hyperinflation after World War I, which made the mark worth less than 1
billionth of its former value within a four-year period.
Maintaining the value of money
The government tries to keep supply stable with appropriate fiscal policy.
Monetary policy tries to keep money relatively scarce to maintain its purchasing power, while
expanding enough to allow the economy to grow.

Inflation: Meaning, Features, Types, Causes Effects and Control

Inflation means a state of general rise in prices. It covers several economic and monetary
aspects, so it needs to be understood clearly. Inflation is commonly understood as a situation
in which prices of goods and services constantly rise at a fast pace. Here inflation implies to a
state of rising prices and not a state of high prices.

To understand it better we should understand the following concepts first:

Value of Money: Refers to the Relationship between Value of Money and Price
purchasing power of money or Level:
its buying capacity, i.e., the Money is used as a unit of account and a measure of
number of goods or services value of all other things, thus its own value can be seen
which a unit of money can buy.
in reference to the price of things.
The higher the price level, the smaller is the power of money to purchase and thus the value
of money would be lower and with the lower price level the purchasing power would increase
along with the increase in the value of money.

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Symbolically Vm = 1/P Where,
Vm = Value of money,
P = Price level
Selling price of sugar = 0.20 per kg

Thus, Vm is inversely proportional to P. Unit of money, i.e., one rupee can buy 5 kg of
sugar so, Vm = 5 kg.

If the price falls to Rs. 0.10 per kg, value of

money will be increased to 10 kg. so, Vm = 10 kg.

Here we find a change in value of money but good money is the one whose value remains
stable. If the changes in value of money occur, it may cause harmful effects of inflation and
deflation.
Inflation implies to declining value of money and deflation implies to rising value of
money.
Definitions:

Inflation can be defined as following:

“As a state in which the value of money is falling, i.e., prices are rising.” -PROF.
CROWTHER

Here it must be understood that all price rise is not inflation. But the constant rises in prices is
what leads to problems in an economy. In this context PROF. HAWTREY defined inflation
as, ‘the issue of too much currency’. But in this definition, the exact meaning of too much
currency is not clear. In fact, it should be correlated with some economic condition of the
country or economic progress.
MARTIN BRON FENBRENNER and FRANKLYN D. HOLZMAN in their famous survey
article on ‘Inflation Theory’ have defined Inflation as:
“Inflation is a condition of generalized excess demand in which too much money chases
too few goods.”

Therefore the important characteristics of inflation may be summarized as under:

1. Inflation is always associated with a rise in prices which is continuous and persistent. It
should be distinguished from price rise which may occur temporarily or during a cyclical
upswing.

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2. Inflation is a dynamic process which can be observed over the long period.
3. Inflation is basically an economic phenomenon. It originates within the economic system
and is fostered by interaction of economic forces.
4. Excess of demand over the available supply is the hall mark of inflation. It is a condition of
economic disequilibrium.
5. Inflation is generally considered a monetary phenomenon for it is normally characterized
by an excessive money supply. Though all increases in the stock of money may not be
inflationary yet a persistent rise in prices cannot be sustained unless the quantity of money
rises as well.
6. Inflation may be caused by ‘demand-pull’ factors or ‘cost push’ factors or both working
together.
7. Inflation is always cumulative in the sense that a mild inflation in the first instance gathers
momentum leading to rapid price rises. Its effects on an economy depends on how rapid it is.

Types of Inflation:
1. Creeping Inflation:
‘Creeping inflation occurs when there is a sustained rise in prices over time at a mild rate, say
around 2 to 3 percent per year. It is also known as ‘mild inflation’. This type of inflation is
not much of a problem. It is generally known as conducive to economic progress and growth.
In this form the prices rise gradually over a long period.
2. Walking Inflation:
When the rate of rise in inflation is of international range of 3 to 8 percent per annum, it is
called walking or trotting inflation. It is an alarming signal for the government to control it
before it worsens.
3. Running Inflation:
When the sustained rise in prices is over 8 percent and generally around 10 percent per
annum, it is called running inflation. It normally shows two-digit inflation. Running inflation
is a warning signal indicating the need for controlling it. It affects the poor and middle class
people adversely.

4. Hyper or Galloping Inflation:

Hyperinflation occurs when monthly increase in prices is 20 percent to 30 percent or more.
At this stage there is no limit to price rise, and price rise goes out of control. Money becomes
almost worthless causing severe hardship to people. There is complete collapse of currency,
the monetary system collapses and the economic and political life gets disrupted.

5. Open Inflation:

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 Inflation become open when there is no barrier to price rise. It occurs in the economy where
there are no control and checks on price rise. Rising prices by large magnitude is the
symptom of open inflation.
6. Suppressed Inflation:
Suppressed inflation refers to a situation when there exists inflationary pressures in the
economy but prices are controlled by certain administrative measures, such as price-control
and rationing. The increase in prices are suppressed (or repressed) here. However, prices rise
by large magnitude after the price controls are removed.
The symptoms of suppressed inflation are long queues of buyers at government controlled
ration shops and the existence of excess demand and black- markets. The controls ensued by
the government on the prices of essential commodities in times of war is an example of
suppressed inflation.

CAUSES OF INFLATION
The traditional explanation of inflation runs in terms of forces operating from the demand and
supply ends. Inflation originating from the demand forces (demand of goods and services) is
commonly referred to as demand pull inflation. On the other hand, inflation originating from
the forces operating from the supply side or increase in cost of production is known as cost
push inflation.

Demand Pull Inflation:

Demand pull inflation occurs when the demand for goods and services exceeds the supply
available at existing prices, i.e., when there is excess demand for goods and services.
Aggregate demand refers to the total demand for goods and services in the economy.

Aggregate demand may increase due to increase in consumption expendi-ture, an increase in

investment expenditure or government expenditure or increase in money supply. Through any
source if the aggregate demand rises rapidly and exceeds the economy’s production, prices
will begin to rise more and more rapidly. The demand for money will beat the limited supply
of commodities and will bid up the prices. Excess demand which exceeds the supply
available at the existing prices will pull up the price level and will lead to emergence of
inflation. When aggregate demand exceeds aggregate supply at full employment level, the
gap between these two {i.e., AD and AS) arises. This gap (which is technically termed as
inflationary gap) leads to rise in prices. The larger the gap, the greater will be inflation.

• If the economy is at or close to full employment, then

an increase in aggregate demand (AD) leads to an
increase in the price level (PL). As firms reach full
capacity, they respond by putting up prices leading to
inflation. Also, near full employment with labour
shortages, workers can get higher wages which
BUSINESS
increase ECONOMICS UEC1301
their spending power.
• D can increase due to an increase in any of its
components C+I+G+X-M
• We tend to get demand-pull inflation if economic
 Cost Push Inflation:
Another explanation of inflation is in terms of forces operating from the supply side or the
cost side. It is known as supply or cost theory of inflation, popularly known as cost push
inflation. Cost push inflation refers to inflationary rise in prices due to increase in costs. Cost
push inflation is caused mainly due to increase in cost of wages and increase in profit margin.
The primary cause of cost push inflation is the rise in money-wages in excess to rise in
productivity of labour. Strong trade unions are able to press employer to grant money for
wage-rate increase in per unit cost. As a consequence, producers raise their prices to cover
the higher cost. A series of increased wage-rates leads to a simultaneous increase in inflation.

Cost-push inflation

• If there is an increase in the costs of firms, then businesses will pass

this on to consumers. There will be a shift to the left in the AS.
• In addition to aggregate demand, aggregate supply also generates
inflationary process. As inflation is caused by a leftward shift of the
aggregate supply, we call it CPI. CPI is usually associated with non-
monetary factors. CPI arises due to the increase in cost of produc-
tion. Cost of production may rise due to a rise in cost of raw
materials or increase in wages.
• However, wage increase may lead to an increase in productivity of
workers. If this happens, then the AS curve will shift to the right-
ward not leftward—direction. We assume here that productivity
does not change in spite of an increase in wages.
• Such increases in costs are passed on to consumers by firms by rais-
ing the prices of the products. Rising wages lead to rising costs.
Rising costs lead to rising prices. And, rising prices again prompt
trade unions to demand higher wages. Thus, an inflationary wage-
price spiral starts. This causes aggregate supply curve to shift
leftward
The Causes of Demand Pull Inflation or Demand Pull Factors:
1. Increase in Public Expenditure or Increase in Government Deficit- Government deficit
increases when the public expenditure increase and the government fails to mobilize
sufficient funds to meet its expenditure.

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The public sector expenditure during The First Plan was Rs. 1,960 crores which increased to
Rs. 2, 20,000 crores during Seventh Plan and to Rs. 23, 68,530 crores during Tenth Plan. This
tremendous increase in Government expenditure has led to the increase in demand for goods
and services but the availability of these has not increased proportionately and under such
conditions, the price rise is natural. In order to meet this expenditure the government prints
new currency. This is called deficit financing. Additional money in the economy leads to a
rise of increased demand for goods and services without a corresponding increase in supply
of goods and services, thus the general price level goes up. This results in ‘deficit induced
inflation’.
In India, the deficit financing was Rs. 330 crores during First Plan, which went up to Rs.
14,000 crores in Seventh Plan and to Rs. 20,000 crores in Eighth Plan. But the supply of
goods and services did not increase and ultimately affected the prices of almost all items.
2. Increase in Income:
With the increased income of people, rises the demand for the goods and services and hence
their prices.
3. Decrease in Taxes or Hoarding of Black Money:
Black money means unaccounted money. It is created through tax-evasion and is responsible
for price-rise. Black money is spent on non-productive activities like buying real estate, gold
smuggling, luxurious living, etc. Black money generates hoarding of goods in the economy.
4. Increase in Population:
It is another major cause for rise in prices. Increase in population refers to increased demand
of consumer goods which puts a pressure on existing supply of goods and services, thus
resulting in inflation.
5. Increase in Export Demand:
Expansion in foreign demand and consequent expansion in exports will raise the incomes of
poor people. This will push up demand for goods & services within the country.
The Causes of Cost Push Inflation or Cost Push Factors
1. Fluctuations in Output and Supply:
The wide fluctuations in production of food grains have been mainly responsible for price
rise. There was a remarkable increase in production of food grains during first two plans and
supply of food grains was good. But fluctuation in food grain production, support prices
administered by Government, the tactics of hoarding adopted by the middlemen and
subsequently by the farmers to resulted in an increase in price. This price increase can lead to
inflationary trend in the economy.
2. Public Distribution System:
The defective working of the public distribution system results in an uneven supply of
various goods, ultimately affecting the prices of essential commodities by way of artificial
scarcity.

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3. Rise in Wages:
The rise in the general price level raises the cost of living which, in turn, leads to demand for
higher wages by workers. When the demand for higher wages is met, it leads to further rise in
costs or prices. The fresh rise in prices will again be compensated by giving still higher
wages to the workers. This is termed as ‘wage push inflation’. Rise in wages has been
considered the main determinant of cost push inflation because in modern times, workers
have organized themselves into strong trade unions which have succeeded in getting higher
wages for their members. When price rises due to rise in wages, it is called wage inflation.
Wage increases are induced mainly by the following factors in operation:
(i) Excess demand for labour. (ii) Increase in cost of living.
(iii) Increase in productivity of labour and resultant demand for more than proportionate
wages.
(iv) Substantial control over the supply of labour.
4. Increases in Profit Margins:
High profit margins on the part of producers due to their monopolistic position raise the cost
of production which in turn pushes up the prices. This kind of inflation is termed as profit
induced inflation.
5. Enhanced Taxation:
With every year’s budget, the government imposes fresh commodity taxes. It leads to an
increase in prices of different commodities in general which in turn push up all the prices.
The railway budget, sales tax, excise duty, etc., directly affect the prices of all types of
commodities.
6. Administered Prices:
The prices of cement, steel, coal, fertilizers, etc., are increased regularly by the public sector
which also add to rise in costs of different factors of production and cause price rise in
general.
7. Oil Price Hike or Rise in International Prices:
Global inflation and hike in oil prices has resulted in higher import of crude oil from abroad.
It results in rise in prices of diesel, petrol and other petroleum products in India. This leads to
higher transport costs and electricity generation.

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Effects of Inflation:
(I) Effect on Production:
During inflation, the producers and businessmen gain in the short-period. Usually the cost of
production does not rise as fast as the price of their product and so there is an artificial margin
of profit. As against this, they may also be affected adversely in the long run. If the price
level goes on increasing, the total consumption of their product would fall.
The reduced consumption will ultimately raise the cost of production per unit and reduce the
profits.

1. Misallocation of Resources and Disrupted Price Mechanism:

Inflation disrupts the smoothness of price mechanism. It finally ends in mal-adjustments in

production. Producers turn towards more production of luxury goods which are non-essential
over essential commodities, from which they expect higher profits.
2. Hoarding:
In times of inflation, people, like traders hoard stocks of essential commodities with an idea
to earn more profits in the near future. As a result, the available supply of goods in relation to
increasing monetary demand, decreases. This results in black marketing, i.e., artificial
scarcity of goods in the market.
3. Encourages Speculation:
A non-anticipated steep rise in prices creates a situation of uncertainty in the economy.
People indulge more in speculative activities than in increasing production.
4. Lack of Quality Control:
Inflation tries to create a sellers’ market. Sellers get a command on prices because of
excessive demand in the market. In such conditions, the sellers overlook the quality of their
goods, instead they concentrate more on earning great profits.

(II) Effect on Distribution of Income:

Inflation redistributes income because prices of all factors do not rise in the same proportion.
Here, prices rise faster but incomes do not. There is an inequality in distribution of wealth.
During inflation, producers and traders are the gainers. As a result, rich get richer and poor
get poorer. It leads to concentration of wealth in the hands of a few rich people.
(III) Other Effects:
1. Cost Increases:

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As prices increase, cost of projects both in private and public sectors goes-up. Consequently,
the total outlay of each plan exceeds the one provided as per original plan yet physical targets
are not fully achieved.
2. Effect on Economic Development and Reduction in Savings:
Due to rise in prices, economic development of a country has adverse effects on savings and
investments.
3. Wage Spiral:
A rapid increase in prices is not suitable as workers demand more wages. Under such
circumstances, wages are raised to compensate the workers. Thus, price spiral affects the
economy.
4. Effect on Foreign Investment:
A rapid increase in prices has an adverse effect on the foreign investment in the country.
Foreign investors do not invest their money in those countries where the value of money is
falling on account of rise in prices. Value of money falls and the investors suffer losses.
5. Adverse Balance of Payment:
Price rise has an adverse effect on the export of the country. Exporters fail to increase the
exports to the desired extent. Actually, our exportable become relatively expensive in the
world market, resulting in the fall of export and our importable become relatively cheaper,
this increases our imports. The demand for country’s exports decreased and imports
increased. Therefore, balance of payment continues to be unfavourable.
How to Curb (Control) Inflation?
Inflation is harmful for the economy if not checked on time. Primarily there are two
categories of measures i.e., monetary measures and Fiscal measures which are to be taken by
government to control inflation but there are other measures also which can be taken by
government to curb inflation.
They are following:

i. Monetary Measures:

Monetary measures are taken by a country’s Central Bank (Reserve Bank of India in India)
on behalf of the government. The monetary measures in detail will be discussed in the next
chapter. Monetary measures work through changes in the quantity of money and rates of
interest.
For example- Reserve Bank of India or RBI frequently changes the repo rate and reverse repo
rate to bring changes in the lending rate of interests of the banking system. The rise in repo
rate makes the borrowing from RBI costlier for commercial banks, which makes lending by
commercial banks costlier.

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So the demand for credit by bank customers falls and so the excess demand. This reduces the
inflation. Similarly by increasing Cash Reserve Ratio, Statutory Liquidity Ratio and Margin
requirements, the supply of money is reduced and loans are made costlier. This controls the
inflation.
Technically the monetary measures taken by RBI can be divided into quantitative and
qualitative measures
QUANTITATIVE MEASURES

Bank Rate Open Market Changes in

Policy Operations Reserve Ratios

QUALITATIVE MEASURES

Regulation
Change in
Moral of Rationing Direct
Margin Publicity
Suasion Consumer of Credit Action
Money
Credit

ii. Fiscal Measures:

Fiscal measures are taken by the government directly. Fiscal measures work through the
government expenditure and tax rates. When the government spends money on various head
like road and dam construction, subsidies, salaries of ministers and administrative employees
and many other heads, etc., it supplies money in the form of incomes. Thus by reducing
expenditure, the government may reduce the supply of money and inflationary pressure.

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Similarly, by increasing taxes government may also reduce the purchasing power in the hand
of the people, hence reducing the inflationary pressure in the economy.

Deflation:
A sustained fall in general price level is called deflation. Deflation is a decrease in the general
price level of goods and services. Deflation occurs when the inflation rate falls below 0%.
Inflation reduces the real value of money once time. Deflation is different from disinflation
which is a slowdown in the inflation rate, i.e., when inflation declines to a lower rate but is
still positive.

What Causes Deflation?

Deflation can be caused by a number of factors, all of which stem from a shift in the supply-
demand curve. The prices of all goods and services are heavily affected by a change in supply
and demand. If demand drops in relation to supply, prices have to drop accordingly.
Likewise, a change in the supply and demand of a national or single-market currency (such as
the U.S. dollar or the E.U. euro) plays an instrumental role in setting the prices of the
country’s goods and services.
Deflationary Spiral Supply Demand
Although there are many reasons why deflation may take place, the following causes seem to
play the largest roles:
1. Change in Capital Market Structures
When many different companies are selling the same goods or services, they typically lower
their prices as a means to compete. Often, the capital structure of the economy changes and
companies have easier access to debt and equity markets, which they can use to fund new
businesses or improve productivity.

There are multiple reasons why companies might have an easier time raising capital, such as
declining interest rates, changing banking policies, or a change in investors’ aversion to risk.
However, after they’ve utilized this new capital to increase productivity, businesses have to
reduce their prices to reflect the increased supply of products, which can result in deflation.

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2. Increased Productivity
Innovative solutions and new processes help increase efficiency, which ultimately leads to
lower prices. Although some innovations only affect the productivity of certain industries,
others may have a profound effect on the entire economy.
For example, after the Soviet Union collapsed in 1991, many of the countries that formed as a
result struggled to get back on track. In order to make a living, many citizens were willing to
work for very low prices, and as U.S. companies outsourced work to these countries, they
were able to significantly reduce their operating expenses and bolster productivity.
Inevitably, this increased the supply of goods while decreasing their cost, which led to a
period of deflation near the end of the 20th century.

3. Decrease in Currency Supply

Currency supplies generally decrease due to actions taken by central banks, often with the
explicit aim of tamping down inflation
Likewise, spending on credit is a fact of life in the modern economy. When creditors pull the
plug on lending money, consumers and businesses spend less, forcing sellers to lower their
prices to regain sales. This is why one of the Federal Reserve’s top priorities today is
ensuring the smooth functioning of credit markets.

4. Austerity Measures
Deflation can be the result of decreased governmental, business, or consumer spending,
which means government spending cuts can lead to periods of significant deflation.

To sum it up, when consumers and businesses cut spending, business profits decrease, forcing
them to reduce wages and cut back on investment. This short-circuits spending in other
sectors, as other businesses and wage-earners have less money to spend. Short of a massive
monetary stimulus that can swing the pendulum too far in the other direction and precipitate
runaway inflation – which central banks try to avoid at all costs – there’s no easy way out of
this cycle.

Effects of Deflation
Deflation is like a terrible storm: The damage is often intense and takes far longer to repair
than the storm itself.
Deflation may have any of the following impacts on an economy:
1. Reduced Business Revenues

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Businesses must significantly reduce the prices of their products in order to stay competitive.
As they reduce their prices, their revenues start to drop. Business revenues frequently fall and
recover, but deflationary cycles tend to repeat themselves multiple times.
Unfortunately, this means businesses need to increasingly cut their prices as the period of
deflation continues. Although these businesses operate with improved production efficiency,
their profit margins eventually drop, as savings from material costs are offset by reduced
revenues.

2. Wage Cutbacks & Layoffs

When revenues start to drop, companies need to find ways to reduce their expenses to meet
their bottom line. They can make these cuts by reducing wages and cutting positions.
Understandably, this exacerbates the cycle of inflation, as more would-be consumers have
less to spend.

3. Changes in Customer Spending

The relationship between deflation and consumer spending is complex and often difficult to
predict. When the economy undergoes a period of deflation, customers often take advantage
of the substantially lower prices that result. Consumers who have lost their jobs or taken pay
cuts must start reducing their spending as well. Of course, when they reduce their spending,
the cycle of deflation worsens.
4. Reduced Credit and investment
When deflation rears its head, financial lenders quickly start to pull the plugs on many of
their lending operations for a variety of reasons. First of all, as assets such as houses decline
in value, customers cannot back their debt with the same collateral. In the event a borrower is
unable to make their debt obligations, the lenders will be unable to recover their full
investment through foreclosures or property seizures. Also, lenders realize the financial
position of borrowers is more likely to change as employers start cutting their workforce. .
Investors watch their money grow simply by holding onto it Central banks might try to
reduce interest rates to encourage customers to borrow and spend more, but many customers
still won’t be eligible for loans.

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(Extra Just for Info)
Historical Examples of Deflation: A quick Reality Check up on how inflation and deflation is
managed
Although deflation is a rare occurrence in the course of an economy, it is a phenomenon that
has occurred a number of times throughout history. These are some of the most noteworthy
incidents.

1. Early 20th Century: Great Depression

The Great Depression was the most financially trying time in American history. During this
dark period, unemployment spiked, the stock market crashed, and consumers lost much of
their savings. Employees in high-production industries such as farming and mining were
producing a great amount but not getting paid accordingly. As a result, they had less money
to spend and were unable to afford basic commodities, despite how much vendors were
forced to reduce prices.
2. Early 21st Century: European Debt Crisis
The sovereign debt crisis in Europe came to a head in 2011 and caused a number of
complications for the global economy that reverberate to this day. In response to mounting
concerns among bondholders that they would be unable to repay their debts, several
European governments’ implemented austerity measures that reduced GDP considerably,
such as cutting government assistance to needy families. Meanwhile, banks tightened up on
lending, reducing the money supply within the country. Widespread deflation was the
predictable result, and while the worst of the crisis has passed, the European economy
remains weak.

Tools to Fix Deflation

It’s possible to reduce the impact of deflation. But it requires a disciplined approach, as
deflation is not something that fixes itself.
Before the Great Depression, the economic consensus held that deflation was a temporary
condition that runs its course without government or central bank intervention. However, the
experience of the Great Depression, the most severe economic downturn in U.S. history,
convinced economists and policymakers otherwise.
Today, central banks are the most important forces in the fight against deflation (and
inflation) due to their mandate to control national monetary supplies. For example, during the
global financial crisis and its long aftermath, the Federal Reserve engaged in multiple rounds
of quantitative easing in an effort to stave off deflation. While increasing the nation’s

BUSINESS ECONOMICS UEC1301

monetary supply too much could create excessive inflation, a moderate expansion in the
nation’s monetary base is an effective means of fighting deflation, at least in theory.

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BUSINESS ECONOMICS UEC1301