Policies to control inflation, Phillip's curve

1. CONTROL OF INFLATION
Prof. Prabha Panth,
Osmania University,
Hyderabad
20-Dec-18

2. Control of Inflation
• Inflation occurs due to mismatch between D
and S.
• Disequilibrium situation.
• Measures to control inflation address:
o Reduction in D
o Increase in S to correct the disequilibrium
• Macro Policy measures include:
o Monetary Policy,
o Fiscal Policy
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3. 1. Monetary Policy
• Monetary Policy: policy of the Central Bank,
(RBI)
• Acts on Government’s orders.
• Controls Supply of money with the public, to
reduce D.
• Based on Quantity theory of Money.
o Supply of money with public falls
o Demand for goods fall,
o Prices fall, inflation is controlled.
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4. Instruments of Central Bank
• Money supply = cash + credit (bank deposits
in commercial and central banks)
• To reduce money supply with the public,
with the commercial banks, and with
government.
• Two main instruments of credit control
1. Quantitative Measures,
2. Qualitative Measures
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5. 1. Quantitative Measures
1. Bank Rate:
• Bank Rate: rate at which CB gives long term credit
to commercial banks. No securities needed.
o Repo Rate = 8 %. Short term loans by commercial
banks from RBI (keeping securities for buy back).
o Reverse repo rate= 7%. RBI buys securities from
Commercial banks.
• During inflation, Bank Rate increases.
o Discourages Commercial banks borrowing from CB,
o Commercial banks increase own interest rates.
o Discourages borrowing by the public,
o Encourages savings.
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6. 2. Open Market Operations (OMO):
• CB buys and sells shares and securities in the
Open Market (Stock Exchange).
• During inflation, it sells its own shares and
securities in the Open Market.
• Commercial banks, other financial companies,
and public buy them.
• This reduces their cash in hand, and credit,
• Fall in money supply  D   P 
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7. 3. Cash Reserve Ratio (CRR):
• CB is the Banker’s Bank.
• Commercial banks must keep a minimum, at
least 3% of their cash deposits with CB.
• During inflation, CB increases CRR. (In India
CRR = 4.75%)
• Cash and credit with Commercial Banks fall.
• They reduce their own lending to public.
• Fall in money supply  D   P 
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8. Qualitative or Selective Credit
Controls
1. Margin Requirements: Entire loan amount is
not given to the borrower.
• some % of it is retained by the commercial
bank.
• During inflation, this ratio is increased by CB.
• So loan amount actually given is reduced.
• Statutory Liquidity Ratio (SLR): minimum %
of deposits that commercial banks have to
maintain in form of gold, cash or other
approved securities. (23% of deposits).
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9. 2. Consumer Credit: loans for buying houses,
cars, TV sets, etc is reduced during inflation.
Decreases down payments, reduces time for
repayment of instalments.
3. Direct Action: against erring banks, who do
not follow the CB’s directives.
• Will not grant them loans, or help them during
exigencies.
• Take over or closure of such institutions.
• Lesson to others who disobey injunctions.
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10. o Monetised economy and money market,
o Higher interest rates  luxury goods not
affected, pass on higher costs of borrowing to
the public. Prices rise.
o Investment in Capital formation , growth
rate falls.
o Small farmers, traders, small and medium
scale industries cannot afford higher interest.
o Output of essential goods 
o Supply , prices 
Impact of Monetary Policy:
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11. Fiscal Policy
1. Reduce Expenditure: Government cuts down
unnecessary expenditure.
• Reduces pumping more money into the
economy.
2. Increase in Direct Taxes: Income, Profit tax,
Property tax, to reduce supply of money.
3. Public Borrowing: Removes cash with the
public. High interest rates, gilt edged.
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12. Fiscal Policy
4. Increase supply of goods: Government
investment, or imports.
o In less developed countries, increase in supply
more important than controlling demand.
o Government investment and encouragement in
essential goods production should increase.
5. Control over increase in wages and salaries.
6. Price Controls and rationing.
7. Subsidise essential goods and services.
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13. Growth and Inflation
• Developing economies: Economic growth is
necessary.
• Large scale investments in Heavy, Basic, and
Infrastructure.
• Long gestation lags (time between Investment
and production of output).
• Ys and D for necessaries increase, not output.
• Prices rise. Such investments called Inflation
Creating Activities.
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14. • To reduce rising prices, investment in quick
yielding consumer necessaries required.
• E.g. in agriculture, small scale production of
consumer goods, housing, etc.
• Called Inflation Dampening Activities.
• Increase in Supply = increase in D for
essentials.
• When both are in correct proportions
(Balanced Allocation Ratio), then inflation can
be controlled.
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15. Phillips’s curve
• The Phillip’s Curve shows an inverse
relationship (trade off) between unemployment
and wage inflation.
• At full employment, there is competition for
labour .
• Drives up wage rate.
• “Cost Push Inflation”, Ps  to maintain profits.
• Workers’ real wages will not increase, as P is .
• Again demand a rise in nominal wage rates.
• More inflation.
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16. The Phillip’s Curve
Phillip’s curve
Rateofwageinflation%
Unemployment rate %0
A
2%
B
4%
8%
5%
• Unemployment, wage inflation
• Or unemployment , inflation 
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17. • The Phillip’s curve causes a dilemma to
governments.
o If it reduces unemployment, leads to inflation.
o If it tries to control inflation, unemployment increases.
• So some acceptable level of both unemployment
and inflation should be found.
• Phillip’s curve hypothesis broke down, due to
stagflation during the 1970’s.
• Stagflation: Stagnation (unemployment) +
inflation.
o Due to increase in international oil prices,
o And Ratchet effect of higher wages.
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