Saturday, May 7, 2011

What is inflation is all about?

Do we know what is inflation is all about?  Let's brush up the basics now.

Barter System:

Before the advent of money, there was barter system. Unlike money economy, the barter system had many difficulties and disadvantages. Take an example, imagine that you have a pen and you need a pencil and your friend has a pencil and he needs a paper. Even though your friend has pencil which you need, you cannot get it from him because the paper he needs is not with you. This is one of such difficulties of the barter system and it is known as 'double coincidence of wants'.

The pen you have could not be exchanged for the pencil you need. So, pen is not a 'medium of exchange'. Medium of exchange i.e.,'money' is something which could be exchanged for anything else. So many things (that are thought to have value) served as 'mediums of exchange' during different times and different parts of world. Gold, silver, copper, salt, peppercorns, large stones, shells, alcohol, cigarettes are but few examples of 'mediums of exchange'.

Precious Metals as Medium of Exchange:

Over a period of time, coins of precious metals became standard 'medium of exchange'. As there was the problem of wear and tear during the course of handling of these coins which reduced the value of these coins, a method was devised. The government would get the coins of precious metals and issue paper money of equivalent value. The paper money issued by the government could be given back to it anytime and the precious metals of equivalent value would be returned. The power of government to issue paper money was limited only to the amount of precious metals it has. This was followed by most of the modern governments till the middle of this century and it was called 'gold standard'.

Paper Money:

The population is always growing but not the supply of precious metals. To meet the needs of growing population, governments need more paper money. So, how can a government tackle the problem? It can issue paper money in excess of the precious metals it has. Are any of the governments doing this now? Yes. Invariably all the governments do this. And it is called 'minimal reserve system' which means any government must have precious metals of certain minimum value and can issue paper money to any extent.

What is the problem with this arrangement? Suppose that the government issued paper money in excess of the precious metals in its possession. What happens if all the people who had paper money want to get the equivalent precious metals back from the government (this is not possible now) ? The Government could not give all the people their precious metals. The direct consequence of this that people lose faith in the paper money issued by the government and the value of it gets reduced. This is 'inflation'.

The value of money is persistently getting decreased even though government makes effort to control it. How do you know that the value of money is decreasing? Simply, the money could not purchase the same amount of goods or services as it did earlier. Suppose that your monthly budget for the last year is Rs.5,000/- and now the same has risen to Rs.7,500/- without any major or significant change in the goods or services you bought last year, it is evident that the value of money has depreciated. The 'purchasing power' of money has become less which signifies 'inflation'.

What is inflation?

inflationThe word 'inflation' itself shows that the money is circulating more than a country needs it. Simply, there is excess money in the country. What are the causes? There are 2 major causes for inflation. 1) Demand-pull inflation 2) Cost-push Inflation. Demand-pull inflation is a situation where more money is chasing few goods / services. Obviously, when demand increases the price increases. The second type of inflation 'Cost-push inflation' is caused by the increase in the cost of production of goods / services which may be due to rise in the wages of employees or the rise in the cost of raw materials.

What does government do to control inflation?

It can either reduce the supply of money or decrease the demand for money. How can it achieve this? A government can ask banks to lend less which reduces the supply of money or it can just increase the interest rates which obviously will decrease the demand for money. In most of the countries this management of money is not directly done by the governments but by the central banks ('Reserve Bank of India' in our country) and the policy that these central banks make regarding this is known as 'monetary policy'.

To quote one interesting method central banks follow to reduce supply of money is manipulating the 'cash reserve ratio'. Suppose that our country has only one bank and it has got only Rs.100/- as its deposit. How much can it lend? Rs. 25/-? Rs.50/-? Or Rs.99/-? It may be surprising to know that with Rs.100/-, a bank could lend up-to Rs.10,000/- with a 'cash reserve ratio of 10%. How is it possible? It is theoretically possible. Consider the 'cash reserve ratio' is 10% which means the bank should keep 10% of its deposits as reserve. So, with Rs.100/- it can lend Rs.90/-. Theoretically, this Rs.90/- is going to come into the banking system again as a deposit. So, now the bank gets Rs.90/- as a fresh deposit from which it could lend Rs.81/- (i.e., Rs.90 – 10% of Rs.90/- (which is 'cash reserve ratio')). It already lent Rs.90/- and now it has lent Rs.81/- and the total is Rs.171/-. If you continue this calculation, with a 'cash reserve ratio' of 10% a bank could lend up to 10 times of its deposit.

The formula is simple:

Number of times a bank
could lend its deposits } = 100 / Cash Reserve Ratio

In our example we have taken 'cash reserve ratio' as 10%, so 100/10 which equals 10 is the amount of times bank could lend which is Rs.1,000/-.  Just increase the 'cash reserve ratio' to 20% and the amount of money the bank could lend is dropped to Rs.500/- But, it is not sure that every bank of an economy would exactly lend proportionate the 'cash reserve ratio'. It is but one technique handled by the central banks to decrease the money supply.

There are many other confusing rates and ratios such 'Prime Lending Rate', 'Statutory Liquidity Ratio', 'Repo Rate' Reverse Repo Rate' etc., which central banks use to contain inflation. All the methods central banks use to control are not complex. They may also be so simple such as releasing a long term government bond (for example 'Indra Vikas Patra') to suck out the excess money or reducing the number of transactions that could be done in a savings bank account.

Measures of Inflation:

How is inflation measured? There are again two types of measuring it 1) Whole Sale Price Index 2) Consumer Price Index. Whole sale price index, as the name indicates, measures the increase the cost of production. And the Consumer price index measures the cost of living. Both of these indices have separate basket of goods / services whose rise in price is measured and are compared with those of the previous week, month or years indices and the percentage with which it differ with those indices are announced as 'inflation rate'.

Necessary Evil:

Can an economy be without inflation? It is impossible. Because as the population grows the government must ensure that everyone is getting enough money for their living which will obviously increase the amount of money being circulated in an economy which ultimately causes inflation. Hence, inflation is unavoidable but it must be kept in control. George Bernard Shaw said "Marriage is a necessary evil", so is the inflation.

Inflation-Certain Economic Terms Explained


It is a percentage of cash every bank has to maintain with RBI. The percentage is fixed by RBI. It is calculated based on the net demand and time liabilities of a bank.

Demand liability is a type of liability in which the amount must be paid on demand. For example, Current Account is a demand liability i.e., the bank must pay the amount (a customer wishes to withdraw) whenever he demands the amount he has in his Current Account.

Time Liability is a type of liability in which the amount becomes payable only on a certain point of time in future. For example, Fixed Deposit is a time liability i.e., the bank must pay the amount (a customer has in his fixed deposit) only on the date it gets matured.


It is a percentage of cash / gold / approved securities that a bank must maintain with itself before lending to the customers. It is calculated based on the total demand and time liabilities of a bank. There is a difference between 'net demand and time liabilities' and 'total demand time liabilities'. The methods of calculating both are different which are prescribed by RBI.

The difference between CRR and SLR is that in CRR, banks has to maintain Cash balance with RBI whereas in SLR, banks can maintain themselves the prescribed percentage (by RBI) of reserve not only in Cash but also in gold or approved securities. Both CRR and SLR are tools of monetary policy. But the SLR makes banks to invest some portion of money in Government Securities ('gilt edged securities') which are totally risk-free. The purpose of both CRR and SLR are to curb the lending ability of banks and suck out excess money from the economy.


REPO stands for 'Re-Purchase Option'. The concept behind REPO is simple. Let us consider there are 2 persons 'A' and 'B'. Let us suppose 'A' has got securities (i.e., shares, bonds etc.,) and 'B' has cash. 'A' wants cash. 'A' signs an agreement with 'B' stating that

  • 'A' will give securities to 'B' and get the equivalent cash from 'B'.
  • 'A' will pay a fixed rate of interest to 'B' for the cash he borrowed from 'B'.
  • 'A' will buy back (Re-Purchase) the securities (that he gave to 'B') at a fixed future date and fixed price.

This arrangement for 'A' (borrower) is "REPO" because he has agreed to repurchase the securities he has given to 'B' and for 'B' (lender) it is "Reverse REPO". Simply 'REPO' and 'Reverse REPO' are one and the same viewed for different angles. For who borrows money it is 'REPO' and for who lends money it is 'Reverse REPO'. The same is true for 'REPO Rate' and 'Reverse REPO Rate'. The fixed interest 'A' and 'B' agree to is 'REPO Rate' for 'A' and 'Reverse REPO Rate' for 'B'.

In our country, both the 'REPO Rate' and the 'Reverse REPO Rate' are viewed only from the angle of RBI which fixes both the rates. Hence, when banks give the securities they hold to RBI and borrow money, the interest rate paid by the banks to RBI is 'REPO Rate'. When the RBI gives the securities it holds to the banks and borrows money, the interest rate paid by RBI is 'Reverse REPO Rate'. RBI employs both these rates to suck out excess money in short-term. Also for RBI, there is no need to money borrow money from banks. But it does so to absorb the excess money circulating in the economy.

When 'REPO Rate' is high, banks will not borrow much from RBI and vice-versa. When 'Reverse REPO Rate' is high, banks will find RBI an attractive destination to place their excess money (as RBI will pay more interest to banks).


'Prime Lending Rate' or 'Prime Rate' is an interest rate banks lend money to their most favoured and credit-worthy customers. In our country (till June 30, 2010), 'Benchmark Prime Lending Rate' (BPLR) was followed.

What is the difference between 'PLR' and 'BPLR'?

Simply, there is no major difference between 'PLR' and 'BPLR'. 'PLR' was renamed as 'BPLR' but the concept remained same .  Then why it is called 'Benchmark PLR'?  Because, the interest rates bank charge to all other customers must have reference to BPLR, ie., any other interest rates must specify how much percent it is high / low from BPLR.

The problem with BPLR is that more than half of the loans lent by the banks are Sub-BPLR i.e., interest rate below the BPLR. Every bank had its own BPLR and there was no transparency as to how a particular interest rate above / below BPLR was set by a bank. It may be interesting to note that the recent worldwide financial crisis was due to 'Sub-Prime Lending'.


Now the RBI has changed the BPLR to Base Rate Regime. Base Rate is a interest rate which a bank can set for itself and can also change it from time to time according prevailing conditions. The major difference between BPLR and Base Rate is that banks could not lend below the 'Base Rate'. So, the method of computation of interest rate for various sectors becomes transparent.

No comments:

Post a Comment