CHAPTER 1

INTRODUCTION OF INFLATION

1.1 BACKGROUND OF THE STUDY

Inflation as a topic of study has received broad attention in academic and policy literature over many years. Inflation is a persistent and appreciable rise in the general price level or average of prices. It is said that when the quantity of money used as the medium of exchange in the economy is more than quantity of goods and services, inflation is most probable. This can be caused due to some direct causes such as increase of income or some indirect cause such as political forces in an economy. Since Nepal is currently under transition phase, several factors contribute for the increasing price rate. Increase in income of consumers, credit policy, natural causes, lack of raw materials, techniques of productions, industrial disputes and political factors are some of the causes of inflation in Nepal. The political instability has caused several social problems such as strikes, social insecurity, etc. As such the investors have been highly discouraged. Another factor causing inflation is the credit policy. The demand for credit has been in quite an amount and thus commercial banks have only a smaller amount of money in their cash-fund so that large amount of money is circulated in society. So the increase in use of money in society creates inflation.

Inflation is supposed to have negative effect in an economy but sometimes the inflation of smaller rates can provide some motion to the economy. This sort of motion increases the employment and leads economy towards development. But when the inflation rate is high this will affect the economy negatively such as it creates hindrances in capital formation and creation of black market. So inflation is not necessarily bad.1.2 MEASUREMENT OF INFLATION

Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. People consider the rate of inflation important because it affects their planning. The price at which people borrow and lend funds will also depend heavily on what they expect to happen to prices.

Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index. The inflation rate is the percentage rate of change of a price index over time. There are various indices which measure the price level, such as; consumer price index (CPI): wholesale price index (WPI); sensitive price index (SPI); gross domestic product (GDP) deflator and so on. In Nepal, there are three main price indices, namely: the CPI; the WPI; and the Salary and Wage Rate Index (SWRI). 4 The main focus for measuring the cost of living is placed on CPI.

1.2.1 Consumer Price Index

The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer. CPI is the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in CPI are used to assess price changes associated with the cost of living. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly.1.2.2 Wholesale Price Index

It is also known as Producer Price Index which reflects the wholesale prices of various goods and services, and is similar to the CPI construction. It measures the average change over time in selling price by domestic producers of goods and services. It measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI.1.2.3 GDP Deflator

This is broader measure of inflation. GDP deflator is constructed by taking the ratio of Nominal GDP to Real GDP. This measure is used to calculate the price change or inflation of all goods and services produced in an economy over time. The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure. Unlike some price indexes, the GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people's consumption and investment patterns. The advantage of this approach is that the GDP deflator reflects up to date expenditure patterns

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace.1.3 TRENDS OF INFLATION IN NEPAL

Prices in Nepal are also greatly influenced by inflation in India since the Nepali rupee is pegged to the Indian currency. In Nepal monetary stance cannot sustain prices that differ from Indian prices for a long time as price differentials cause smuggling; changes in monetary posture eventually shows up in the changes in international reserves. The rate of rise in general price level has continued to moderate closer to the target in spite of supply and demand side pressures. Inflation has been high because of imported Indian inflation, high international commodity prices.

Since the average price inflation trends in the last five year has been unstable, it seems challenging to keep the annual inflation rate in stable trends due to supply constraints, frequent price rise of petroleum products, continuous rise in wage rate and pressure from rising food prices in recent period. In addition, the prolonged political instability and lack of investment friendly climate have caused the productivity to decline. Hence, the role of monetary policy seems tough to control the inflation rate within desired level.

The following table shows the trends of inflation rate from 2008 to 2012:

Table 1: Trends of inflation rate

YearInflation, average consumer pricesPercent Change

20087.719.64 %

200913.22671.77 %

201010.512-20.52 %

20119.6-8.66%

20127.5-21.875%

In above table, it has been shown that during 2009 and 2010, there was a double-digit inflation because of world economic recession on 2008 which affects economy of Nepal too. The inflation rate of 2011 and 2012 shows the inflation rate is in decreasing trends. The monetary policy for FY 2012/13 has set the target of attaining economic growth of 5.5 percent, limiting inflation at 7.5 percent and maintaining foreign exchange reserves sufficient to cover imports of goods and services of at least eight months.

Figure 1: Inflation Trends

CHAPTER 2

TRENDS OF INFLATION IN NEPAL

2.1 INFLATION IN NEPALIn Nepal, money supply and interest rate, which are the basic tools of monetary policy, do not seem to have been able to slow down inflation. Since a few years, Nepal has experienced a rapidly rising inflationary trend. These gearing-up dynamics of inflationary trend have rudely shocked different cross-sections of the intelligentsia. In 2013, Nepalese have to endure a high inflation of 10.2 per cent. Taking into consideration the persistently high inflation in Nepal, apart from monetary policy and fiscal policy, the government should pay attention to some of the vital factors in taming inflation. First, oil price fluctuations wield a uniquely critical pressure on inflation throughoutthe world.For meeting the requirement either a dynamo of power should be entrusted to Nepal Oil Corporation, the sole agent of fuel supply or privatize the whole system of importing petroleum products to ensure smooth supply in the market. Second, imported inflation, if strong enough, is heavily anti-cyclical since it stimulates a decrease in output growth.Therefore, it has become inevitable in altering the western practices, style and consumption habits of the majority of the population who belong to the younger generation. Attitudinal changes should be induced aggressively in the habit of purchasing exotic consumer goods.Third, as the country is fully reliant on import of petroleum products the government should pursue on a priority basis means of enhancing renewable energy, wind energy and should briskly indulge in centering its attention on developing micro and macro hydropower as we all know that our countrys import of petrol only exceeds total export value of the country.

2.2 FOOD AND NON-FOOD INFLATIONInflation in Nepal is largely affected by rising food price in the country, which is a global phenomenon also in the present context. The main driving forces behind Nepals inflation - food and nonfood are Indias inflation and movements of international oil prices. However, inflation in food component has come down to single digit after a long time in October 2011. Non food inflation would go higher in the future if the present exchange rate trend (especially USD exchange rate appreciation) still goes to upward direction. Overall consumer price inflation in Nepal has been influenced by rising prices of food and petroleum products and rising inflation India. Although Nepal maintains an open border with India and pegs its currency to the Indian rupee, Nepals inflation rate does not go in lockstep with that of India. Rising inflation in Nepal has been mainly driven by food price inflation.

Eliminating food prices from core inflation may provide an incorrect picture of underlying inflation trends, especially in low income countries, for three primary reasons: First, a core measure of inflation must have the same medium-term mean as the headline measure. However, food inflation is in many countries higher than nonfood inflation, making it likely that a core inflation measure excluding food prices will show lower inflation even in the long run than headline inflation. This is of particular concern among poorer countries, where in some cases food inflation is significantly higher than nonfood inflation. Second, excluding food prices from core measures (or assigning them a lower weight) due to their perceived transience is also in many cases unjustified. In the sample analyzed here, food inflation in many cases is quite persistent, in many countries more so than nonfood prices. This relationship is also particularly pronounced in poorer countries where food is a large share of the consumption basket. In such countries, the slow dissipation of food shocks could lead to higher expectations not only for food inflation but for overall inflation as well. Given the higher volatility of food price shocks, a core inflation measure that excludes food prices will miss these shocks.

2.2.1 Food Inflation and Nonfood Inflation

There are two important points where differences in distribution of food and nonfood shocks can be significant. First, as Stephen Cecchetti (2007) points out, excluding food from a core measure of inflation is only justified when the long-run mean of food inflation is equal to the long run mean of nonfood inflation: if this is not the case, then core inflation will systematically underestimate headline inflation. That is, if policymakers are interested in the overall price level, ignoring food price dynamics only makes sense if these do not impact the long-run price level; if they do, then they have to be taken into account. Second, it is also important to look at the volatility of food price shocks. If food price shocks are more volatile than nonfood price shocks, they add to the noise to signal ratio that policymakers contend with in assessing inflation. The larger and more frequent these shocks to food inflation are, the likelier it is that they not only lead to erroneous diagnoses of the level of underlying inflation, but also the likelier it is that those shocks can affect nonfood prices as well. This propagation mechanism may not exist everywhere, and this possibility is discussed below. If food shocks tend to be small, then even the long-run effect is likely to be minimal. However, if food shocks are larger and more volatile than nonfood shocks, then even if the propagation mechanism is weak, food shocks may have serious knock-on effects on nonfood prices.

Core inflation indices can be derived in many ways, the end result in most advanced economies is to minimize or eliminate volatile categories, which often translates into excluding food and energy. While the greater role of food prices in emerging economies is acknowledged by all central bankers, core inflation measures excluding food price changes are also widely cited and can inform policy decisions. It is not clear, however, that the characteristics of both food and nonfood prices that justify the minimization of food price inflation in advanced-economy core measures apply in developing economies.

The Food and Beverage group makes up of 46.82% of the CPI and the remaining 53.18% is composed of the Non Food and Service group. The index of food and beverage group increased by 8.7% compared to an increase by 7.1% in the corresponding period of the previous year; whereas non-food and services group increased by 11.8% compared to an increase by 7.8% in the corresponding period of the previous year.

Changes in the Food and Beverage Group:

Under the Food and Beverage group, the price index of ghee and oil sub-group, increased the most by 18.7% during the review period, compared to an increase of 12.5% in the corresponding period of the previous year.

Cereals and their products increased by 5% as compared to 2.1% in the previous review period. The price index of tobacco products and sugar, which had increased by 11.4% and 7.8% in the corresponding period of the previous year, went up by 17.9% and 15.4% respectively.

Similarly, the price indices of meat and fish and restaurant and hotel, which had risen by 5.7% and 9.2% respectively, in the corresponding period of the previous year, increased by 13.3% and 12.9% respectively during the review period. The price indices of legume varieties, which had increased by 0.3% in the corresponding period of the previous year, rose by 11.2%.

Food price inflation has a direct correlation with the price of oil and fertilizers used in agricultural production, transportation cost of agricultural products and use of energy in irrigation.

Changes in the Non-Food and Services group:

Within the Non-Food and Services group, the price index of furnishing and household equipment increased by 15.6% during the review period, compared to an increase fo 13.7% in the corresponding period of the previous year; thereby, becoming one of the groups whose price increased the most,

The price indices of transport increased by 15.1%, which had increased by 12.5%in the corresponding period of the previous year. The transport price is heavily influenced by the price of petrol and diesel.

Similarly, the price indices of housing and utilities, the sub-group that represents the highest proportion of the Non-Food and Service group, i.e. 10.87%, increased by 12.6% compared to an increase by 3.5% in the previous year.

The education sub-group increased by 12.5%; it had increased by 8.9% in the corresponding period of the previous year. The only decline was seen in the price index of communication, which decreased by 2.7%. The sub-group had previously decreased by 8.8%.

CPI Components %2011/2012%2012/2013

Food and Beverage 7.18.7

Ghee and Oil12.518.7

Tobacco Products11.417.9

Sugar and Sweets7.815.4

Meat and Fish5.713.3

Restaurant and Hotel9.212.9

Hard Drinks-2.212.1

Soft Drinks4.211.5

Legume Varieties0.311.2

Milk Products and Egg1310.8

Fruits207

Cereals Grains and their products2.15

Vegetables18.84

Spices-8.30.6

Non-Food and Services7.811.8

Furnishing & Household

Equipment13.715.6

Transport12.515.1

Clothing & Footwear15.213.9

Housing & Utilities3.512.6

Education8.912.5

Miscellaneous Goods &

Services9.710.8

Recreation and Culture7.110

Health3.78.1

Communication-8.8-2.7

Fig: CPI based on Groups/Sub-groups, Mid December 2012 (Base Year 2005/06 =100)

Source: NRB2.3 REGIONAL INFLATION SCENARIO (TERAI, HILLS AND KATHMANDU VALLEY)During the review period, the Hilly region saw the price index rise by 11.2% while the Terai region at 11.1%. The index for the Kathmandu valley rose by 8.8%. The increments were 9.6%, 7.3% and 6% respectively in the corresponding period of the previous year.

In the Kathmandu valley, the Food and Beverage group increased by 6.2 % compared to an increase of 7.6% previously, whereas, the Non-Food and Services group increased by 11%, compared to an increase of 4.7% in the previous period.

In the Hilly region, the Food and Beverage and Non-Food and Services groups increased by 9.6% and 12.6% respectively in the review period. They had increased by 11.1% and 8.2% in the previous review period. Similarly, in the Terai region, the Food and Beverage group increased by 10% compared to an increase of 4.4% in the corresponding period of the previous year. The Non- Food and Services group increased by 12% compared to an increase of 9.7% previous review period.

GROUPS AND SUB-GROUPS%2011/2012%2012/2013

CPI: Kathmandu Valley

Overall Index68.8

Food and Beverage7.66.2

Non-Food and Services4.711

CPI: Hill

Overall Index9.611.2

Food and Beverage11.19.6

Non-Food and Services8.212.6

CPI: Terai

Overall Index7.311.1

Food and Beverage4.410

Non-Food and Services9.712

Fig: CPI changes based on regionSource: NRB

CHAPTER 3

CAUSES OF INFLATION IN NEPAL

Nepal is currently under transition phase and thus several factors contribute for the increasing in price rate. Increase in income of consumers, credit policy, natural causes, lack of raw materials, techniques of productions, industrial disputes and political factors are some of the causes of inflation in Nepal. Inflation is caused by an excessive increase in effective demand and production cost in the economy. Normally, it is caused due to the disequilibrium caused in aggregate demand and aggregate supply.

3.1 DEMAND-PULL INFLATION

The demand pull inflation refers to the rise in the general price level when aggregate demand increases much more rapidly than the aggregate supply. It is mainly caused by demand raising factors such as increase in money supply, public expenditure, exports and population and decrease in tax rate. It is mainly characterized by rise in output, income and employment with the rise in price level up to full employment and increase in only price level after full employment.

In the figure above, AD curve intersect AS curve at e1, giving Y1 and P1 the original output and price respectively. A decrease in aggregate demand shift aggregate demand curve to AD3, giving Y3 income level and P3 general price level. Similarly an increase in aggregate demand shifts the aggregate demand curve to AD2, giving Y2 income level and P2 general price level. This happen till AD2 demand curve and corresponding P2 but increase in aggregate demand leads to increase in price level only. Keynes describes such a raise in price level after attainment of full employment output as pure inflation.

The main causes of increase in aggregate demand are as follows - some are related with Keynesians and others with Monetarists:

Increase in money supply and bank credit:

Due to the excess liquidity in the Nepalese market the money supply has been increased and the interest rate has been decreased. As the result, consumption and investment expenditure increase. This leads to an excessive increase in demand which increases the price level.

Reduction in taxation:

The low tax rate increases the purchasing power of people. Hence, if the government reduces the tax rate so as to give relief to the people, the disposable income increases. Consequently the consumption expenditure increases and inflation occurs. However in case of Nepal the tax rate is consistent for a long period of time i.e. VAT is 13%.

Deficit financing of the government:

In Nepal, deficit financing is taken as excess of government expenditure over current revenue and public borrowing. This deficit is financed by borrowing from the central bank and commercial banks. Deficit financing, therefore, leads to increasing money supply and hence is responsible for the price rise.

Increase in private expenditure:

In Nepal, the income of the people has increased due to the increase in economic activities and investment. This has rapidly increased the consumption and investment expenditure. As a result aggregate demand increases and inflation occurs. Shortage of goods and services:

The price level increases when the supply of goods and services are lower in relation to demand. The production and supply decreases in Nepal due to scarcity of factors of production, hoarding by businessman and scarcity of raw materials especially in petroleum products.

Increase in population:

Increase in population is another factor for inflationary rise in prices, particularly in Nepalese context. Increase in population means increase demand for most of the consumer goods. It increases the aggregate demand for goods and services and puts pressure on existing supply of goods and services.

Black Money:

The existence of black money in Nepal due to corruption, tax evasion, gambling, etc. increases the aggregate demand. People spend much unearned money extravagantly, thereby creating unnecessary demand for commodities. This tends to raise the price level further.

3.2 COST-PUSH INFLATIONThe cost push inflation is caused by the monopoly power exercised by some monopoly groups of the society, like labor unions and firms in monopolistic and oligopolistic market setting; it is mainly characterized by fall in output, income and employment with the rise in price level. Cost-push inflation occurs due to increase in cost of production of goods and services in the economy. Cost-push theories of inflation largely attribute inflation to non-monetary, supply-side effects that change the unit cost and profit markup components of the prices of individual products. Sometimes costs may increase simply due to economic booming; for example, increase in general wages because of rapid expansion in demand. The cost of production can be increased if there is wage rate increment from the trade union power proportion compared to the increase in the marginal productivity of the labor. The factor may be the increase in the oil prices.

Due to the increase in cost of production or supply constraints, the Aggregate Supply (AS) curve shifts leftward from AS1 to AS2 to AS3. Consequently, the prices increase from P1 to P2 to P3 thereby leading to decline in output from y1 to y3. A series of increase in cost of production will results in series of upward shift in aggregate supply curve leading to inflationary rise in price.

The main causes of cost-push inflation are:

Increase in wage rate:

The trade unions of Nepal are so strong that they possess some monopoly power due to the political backup. These trade unions are able to raise wages by pressuring the entrepreneurs to grant them increase in money wage in excess of increase in labor productivity. This results in increase in cost of production. Thus inflationary spiral goes on.

Profits: With the motive of increasing profit, Nepalese entrepreneurs increase their profit margin level. Entrepreneurs increase their profit by charging higher price for the commodity. As a result the cost of production increases and inflation occurs. Indirect Taxes:

Increase in indirect taxes in Nepal like excise duty, custom duty increases the cost of living and push up the prices of products. For example, prices of consumer durables, like electronic goods, rise because of higher excise duty and increase the cost of production. Likewise removal of government subsidies means the people have to pay full price or high price.

Hoarding:

Hoarding of commodities, especially by the Nepalese traders by the traders for profiteering, is also responsible for rise in prices. During the period of scarcity and rising prices, traders, merchants and even consumers indulge in hoarding of commodities; goods go underground and this adds to the problem of scarcity and rise in prices.

3.3 EXCHANGE RATE

The rate at which one currency may be converted into another is known as the exchange rate. The exchange rate of the Nepal is pegged with the India. India is the growing economy and the currency of Indian currency is appreciating. When currency appreciates it will create upward pressure in general price level. Around 80% of Nepals import is from India. Finally Nepals import become costlier and price level in Nepal raises.

3.4 INTERNATIONAL REASON

In the modern world, the economy of a country is linked with other countries. The countries like Nepal are dependent on foreign countries for construction materials, raw materials, energy including consumer goods. Hence, if the price consumer goods raw material and capital goods increases in foreign countries, the price in Nepal also automatically increases. If the prices raises due to price rise by foreign countries such as price of oil by OPEC.

3.5 OTHER CAUSES

1. Consumption Habit: In general, the consumption habit of Nepal is more westernized every day. In an economy where more than 65% of the population is below 35 years of age, the younger generations are a way ahead in purchasing consumer durables and canned food items.

2. Heavy Tax Rate: Heavy tax rate is charged on luxurious products especially automobiles as well as in the liquor and in tobacco in Nepal. This increases the price level of the product. Hence increase the inflation.

3. Increasing Foreign Reserve: Increase in level of foreign currency reserve increases the broad money supply (M2). When money in agricultural lands have been degraded due to natural calamities.

4. Banks: The number of bank and financial institution are increasing day by day. This helps to increase the credit availability to the general public. When credit availability increases, the general price level rises.

5. Growing concrete jungles:At present time all we see around us are concrete buildings. Fertile lands have been used for real estate purpose. If this trend goes on for a long time, we can clearly predict that the inflation rate is undoubtly going to rise especially for food items.

6.High labor cost:The prices of items are also high because of the labor costs is very low mainly in terms of people who get paid on daily basis.

7.Transportation charges:Transport entrepreneurs have ganged up to overprice transportation costs because of rise in price of petroleum products.

8. Price of petroleum products:Price of petroleum products has been adjusted several times on the higher side. Such adjustments helped pushing the cost of freight and carriages and cost of other goods and services.

9. Transmission through trade:Furthermore, rising inflation in India is transmitted in Nepal through trade, which is one of the significant factors of increasing inflation rate of Nepal.

10.Seasonal constraints:Seasonal constraints also prompted to push the inflation up in the past. For example, price rise on sugar and sugar.

Inflation Control Measures in Nepal

In view of the serious consequences of inflation, it is essential that inflation must be effectively controlled before it assumes such a serious proportion that it threatens the very existence of the economic and political system of the country.

Some of the control measures are discussed below:

1. Monetary Measures

Monetary policy aims at controlling the supply of money by influencing in availability and cost of bank money or bank credit. Central bank entrusted with the task of enforcing the monetary policy. It is essential to adopt restrictive or dear monetary policy to combat inflation. Restrictive monetary policy is characterized by reducing the availability of bank credit and increasing the cost of credit.

Two types of instruments can be adopted to implement anti-inflationary and restrictive monetary policies, which are discussed below:

Quantitative Measures

Quantitative measures aim at influencing the overall availability of bank credit and its cost. Open market operations, bank rate and legal reserve ratio are the main quantitative credit control measures. As part of open market operations, the central bank is required to sell government securities to the public and financial institutions so as to reduce the cash reserve of the commercial banks. Similarly, the central the minimum reserve ratio which the commercial banks are required to keep with the central bank. An increase in the legal reserve ratio will reduce the cash reserves of the commercial banks. The fall in the cash reserves of the commercial banks will force them to reduce their total advances and loans.Another measure which can be adopted by the central bank to control inflation is to increase the bank rate by the commercial banks in their loans and advances. This will reduce the amount of loans taken be the customers of the commercial banks as the lending becomes costly.

Selective credit control measuresSelective credit control measures aim at influencing the purpose for which bank credit is made available and thereby affect the direction of bank credit. The central bank can increase the margin requirements in case of certain commodities as to reduce the amount of bank credit available to the traders dealing in those commodities. Similarly, the central can issue directives to the commercial banks prohibiting them from lending against certain commodities or it certain regions so as to curb inflationary pressures in selected economic activities. In the same way, central bank can reduce the bank credit to the consumers for the purchase of durable consumer goods by regulating the consumer credit. The central bank can also advise, appeal and persuade the commercial banks by using moral suasion to achieve the same purpose.

The effectiveness of the monetary policy depends upon the extent of control which the central bank has on the money market and the degree of cooperation which it can get from the commercial banks and the commercial banks and other financial institutions. However, monetary policy is not very effective in curbing inflation, particularly in developing countries.

2. Fiscal measuresFiscal policy also can be used to control inflation. Fiscal policy is the policy of the government revenue. Contractionary fiscal policy policy can be used to reduce the aggregate demand and thereby control demand pull inflation. Contractionary fiscal policy is the policy of reducing government expenditure and increasing government revenue. The main tools of fiscal policy are:

Public expenditure

Public expenditure i.e. expenditure by government is an important component of aggregate demand. In order to control inflation it is essential that government expenditure must be reduced. However, part of the government expenditure is of essential nature and, hence , cannot be reduced. Therefore, what is important is that unproductive expenditure of the government, which to some extent is non essential in nature, must be reduced. For example, expenditure on defense and unproductive works should be reduced.

Taxation

The major plank of anti- inflationary fiscal policy is to increase the tax burden by increasing the tax rate and by imposing new taxes. But direct and indirect taxes can be used for this purpose. Direct taxes like income tax, corporate tax, etc reduce the disposable income of the taxpayers and thereby reduce their consumption expenditure. Indirect taxes like sales,tax, excise duties, etc reduce the aggregate demand by making the commodities expensive. In particular, while heavy indirect taxes need to be imposed on those commodities which are consumed mainly by the rich people, some amount of taxes should also be imposed on commodities of mass use.

Public borrowing

Public borrowing enables the government to meet its expenditure and thereby reduces the need for deficit financing. Moreover, public borrowings help in reducing the amount of purchasing power and thereby total demand in the economy. However, if people give loans to the government out of their savings rather than by curtailing their expenditure, the total demand may not fall.

Thus, a decrease in government expenditure and increase in governments revenue producing a surplus budget is a type of fiscal policy which can be used to control inflation.

3. Direct control measures

i) Price control and rationing

A direct measure to control inflation is to introduce price controls and rationing of essential goods. Under price control policy, the government fixes the maximum price at which certain commodities could be sold. Since, the maximum price is set below the free market equilibrium price; price ceiling is likely to create scarcity of commodity. Therefore, price control policy is often accompanied by rationing. Under rationing a specified quantity of goods is given to the consumers at controlled price. Price controls and rationing may be an effective policy in controlling inflation. However, there are various practical difficulties in implementing this policy. Firstly, price controls and rationing can be introduced on a limited scale for a few commodities only. Secondly, price control is likely to give rise to black market. Black market is the market where goods are sold unlawfully at higher prices than the controlled price.

ii) Increasing the availability of goods

The basic solution to the problem of inflation is to increase the availability of goods in the economy. The following measures need to be taken to increase the availability of goods:

Production should be increased. More specifically, production of inflation- sensitive goods need to be increased by allocating more resources, providing subsidies and removing bottlenecks impeding production of these goods.

Domestic production of essential goods may be supplemented by imports of these goods so as to reduce shortages and minimize inflationary pressures.

iii) Indexation

Economists agree that if inflation is to be controlled, its adverse effects on different groups of the society should be minimized. They suggest indexation of prices, wages and contractual obligations with a view to compensating those who lose their real incomes due to inflation. It is defined as a mechanism at which wages, prices and contracts are partly or wholly compensated for changes in the general price level. It is a method of adjusting monetary incomes so as to minimize the undue gains or losses in real incomes of the different sections of the society due to inflation.

P1

P3

P2

AS1

_1450725295.xlsChart1

7.70.1964

13.2260.7177

10.512-0.2052

9.6-0.0866

7.5-0.21875

Inflation, average consumer prices

Percent Change

Sheet1

YearInflation, average consumer pricesPercent Change

20087.719.64%

200913.22671.77%

201010.512-20.52%

20119.6-8.66%

20127.5-21.88%

Sheet1

Inflation, average consumer prices

Percent Change

Sheet2

Sheet3