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. discouraged. s such the investors have been highly nother 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. "ut 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

#easuring inflation in an economy requires ob$ective 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. %eople 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 &onsumer %rice 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 (&%I)* wholesale price index (+%I)' sensitive price index (S%I)' gross domestic product (,-%) deflator and so on. In Nepal, there are three main price indices, namely* the &%I' the +%I' and the Salary and +age .ate Index (S+.I). / The main focus for measuring the cost of living is placed on &%I.

1.2.1 Consumer Pr !e In"e#

The &onsumer %rice Index measures prices of a selection of goods and services purchased by a 0typical consumer1. &%I is the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The &%I is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. &hanges in &%I are used to assess price changes associated with the cost of living. The &onsumer %rice Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer2s overall spending is spent on specific goods and services, and weights the average prices of those items accordingly.

1.2.2 $%o&es'&e Pr !e In"e#

It is also known as %roducer %rice Index which reflects the wholesale prices of various goods and services, and is similar to the &%I 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 0passed on0 to consumers, or it could be absorbed by profits, or offset by increasing productivity. This differs from the &%I in that price subsidi3ation, 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 %%I and any eventual increase in the &%I.

1.2.( GDP De)&'*or

This is broader measure of inflation. ,-% deflator is constructed by taking the ratio of Nominal ,-% to .eal ,-%. This measure is used to calculate the price change or inflation of all goods and services produced in an economy over time. The 4S &ommerce -epartment publishes a deflator series for 4S ,-%, defined as its nominal ,-% measure divided by its real ,-% measure. 4nlike some price indexes, the ,-% deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people2s consumption and investment patterns. The advantage of this approach is that the ,-% 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. 5ver time ad$ustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 2typical consumers2. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. "oth the sorts of goods and services which are included in the 0basket0 and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace.

1.( TRENDS OF INFLATION IN NEPAL

%rices 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. 6ence, 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 7889 to 78:7* Table :* Trends of inflation rate Ye'r 7889 788< 78:8 78:: 78:7 In)&'* on+ ',er'-e !onsumer .r !es Per!en* C%'n-e ;.; :?.77= :8.@:7 <.= ;.@ :<.=/ > ;:.;; > !78.@7 > !9.==> !7:.9;@>

In above table, it has been shown that during 788< and 78:8, there was a double!digit inflation because of world economic recession on 7889 which affects economy of Nepal too. The inflation rate of 78:: and 78:7 shows the inflation rate is in decreasing trends. The monetary policy for AB 78:7C:? has set the target of attaining economic growth of

@.@ percent, limiting inflation at ;.@ percent and maintaining foreign exchange reserves sufficient to cover imports of goods and services of at least eight months.

Aigure :* Inflation Trends

CHAPTER 2 TRENDS OF INFLATION IN NEPAL

2.1 INFLATION IN NEPAL

In 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 78:?, Nepalese have to endure a high inflation of :8.7 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. Airst, oil price fluctuations wield a uniquely critical pressure on inflation throughout the world. Aor meeting the requirement either a dynamo of power should be entrusted to Nepal 5il &orporation, the sole agent of fuel supply or privati3e 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 ma$ority of the population who belong to the younger generation. ttitudinal 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 countryDs import of petrol only exceeds total export value of the country.

2.2 FOOD AND NON/FOOD INFLATION

Inflation 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 NepalDs inflation

! food and nonfood E are IndiaDs inflation and movements of international oil prices. 6owever, inflation in food component has come down to single digit after a long time in 5ctober 78::. Non food inflation would go higher in the future if the present exchange rate trend (especially 4S- exchange rate appreciation) still goes to upward direction. 5verall consumer price inflation in Nepal has been influenced by rising prices of food and petroleum products and rising inflation India. lthough Nepal maintains an open border with India and pegs its currency to the Indian rupee, NepalDs inflation rate does not go in lockstep with that of India. .ising inflation in Nepal has been mainly driven by food price inflation. Fliminating food prices from core inflation may provide an incorrect picture of underlying inflation trends, especially in low income countries, for three primary reasons* Airst, a core measure of inflation must have the same medium!term mean as the headline measure. 6owever, 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 un$ustified. In the sample analy3ed 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. ,iven the higher volatility of food price shocks, a core inflation measure that excludes food prices will miss these shocks.

2.2.1 Foo" In)&'* on 'n" Non)oo" In)&'* on

There are two important points where differences in distribution of food and nonfood shocks can be significant. Airst, as Stephen &ecchetti (788;) points out, excluding food from a core measure of inflation is only $ustified 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. 6owever, 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. &ore inflation indices can be derived in many ways, the end result in most advanced economies is to minimi3e or eliminate volatile categories, which often translates into excluding food and energy. +hile 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 $ustify the minimi3ation of food price inflation in advanced!economy core measures apply in developing economies. The Aood and "everage group makes up of /=.97> of the &%I and the remaining @?.:9> is composed of the Non EAood and Service group. The index of food and beverage group increased by 9.;> compared to an increase by ;.:> in the corresponding period of the previous year' whereas non!food and services group increased by ::.9> compared to an increase by ;.9> in the corresponding period of the previous year.

C%'n-es n *%e Foo" 'n" Be,er'-e Grou.0

4nder the Aood and "everage group, the price index of ghee and oil sub!group, increased the most by :9.;> during the review period, compared to an increase of :7.@> in the corresponding period of the previous year. &ereals and their products increased by @> as compared to 7.:> in the previous review period. The price index of tobacco products and sugar, which had increased by ::./> and ;.9> in the corresponding period of the previous year, went up by :;.<> and :@./> respectively. Similarly, the price indices of meat and fish and restaurant and hotel, which had risen by @.;> and <.7> respectively, in the corresponding period of the previous year, increased by :?.?> and :7.<> respectively during the review period. The price indices of legume varieties, which had increased by 8.?> in the corresponding period of the previous year, rose by ::.7>. Aood price inflation has a direct correlation with the price of oil and fertili3ers used in agricultural production, transportation cost of agricultural products and use of energy in irrigation.

C%'n-es n *%e Non/Foo" 'n" Ser, !es -rou.0

+ithin the Non!Aood and Services group, the price index of furnishing and household equipment increased by :@.=> during the review period, compared to an increase fo :?.;> 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 :@.:>, which had increased by :7.@>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!Aood and Service group, i.e. :8.9;>, increased by :7.=> compared to an increase by ?.@> in the previous year.

The education sub!group increased by :7.@>' it had increased by 9.<> in the corresponding period of the previous year. The only decline was seen in the price index of communication, which decreased by 7.;>. The sub!group had previously decreased by 9.9>.

CPI Com.onen*s Foo" 'n" Be,er'-e ,hee and 5il Tobacco %roducts Sugar and Sweets #eat and Aish .estaurant and 6otel 6ard -rinks Soft -rinks Gegume Harieties #ilk %roducts and Fgg Aruits &ereals ,rains and their products Hegetables Spices Non/Foo" 'n" Ser, !es Aurnishing I 6ousehold Fquipment Transport &lothing I Aootwear 6ousing I 4tilities Fducation #iscellaneous ,oods I Services .ecreation and &ulture 6ealth &ommunication

12231142312 5.1 :7.@ ::./ ;.9 @.; <.7 !7.7 /.7 8.? :? 78 7.: :9.9 !9.? 5.6 :?.; :7.@ :@.7 ?.@ 9.< <.; ;.: ?.; !9.9

1223124231( 6.5 :9.; :;.< :@./ :?.? :7.< :7.: ::.@ ::.7 :8.9 ; @ / 8.= 11.6 :@.= :@.: :?.< :7.= :7.@ :8.9 :8 9.: !7.;

Aig* &%I based on ,roupsCSub!groups, #id -ecember 78:7 ("ase Bear 788@C8= J:88) Source: NRB

7.? REGIONAL INFLATION SCENARIO 7TERAI+ HILLS AND KATHMANDU 8ALLEY9

-uring the review period, the 6illy region saw the price index rise by ::.7> while the Terai region at ::.:>. The index for the Kathmandu valley rose by 9.9>. The increments were <.=>, ;.?> and => respectively in the corresponding period of the previous year.

In the Kathmandu valley, the Aood and "everage group increased by =.7 > compared to an increase of ;.=> previously, whereas, the Non!Aood and Services group increased by ::>, compared to an increase of /.;> in the previous period. In the 6illy region, the Aood and "everage and Non!Aood and Services groups increased by <.=> and :7.=> respectively in the review period. They had increased by ::.:> and 9.7> in the previous review period. Similarly, in the Terai region, the Aood and "everage group increased by :8> compared to an increase of /./> in the corresponding period of the previous year. The Non! Aood and Services group increased by :7> compared to an increase of <.;> previous review period.

GROUPS AND SUB/ GROUPS CPI0 K'*%m'n"u 8'&&e: 5verall Index Aood and "everage Non!Aood and Services CPI0 H && 5verall Index Aood and "everage

12231142312

1223124231(

= ;.= /.;

9.9 =.7 ::

<.= ::.:

::.7 <.=

Non!Aood and Services CPI0 Ter' 5verall Index Aood and "everage Non!Aood and Services

9.7

:7.=

;.? /./ <.;

::.: :8 :7

F -0 CPI !%'n-es ;'se" on re- on Source: NRB

CHAPTER ( 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.

(.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 characteri3ed 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,

- curve intersect

S curve at e:, giving B: and %: the original

output and price respectively.

decrease in aggregate demand shift aggregate demand -7, giving B7 income level

curve to -?, giving B? income level and %? general price level. Similarly an increase in aggregate demand shifts the aggregate demand curve to and %7 general price level. This happen till -7 demand curve and corresponding %7 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 #onetarists*

In!re'se n mone: su..&: 'n" ;'n< !re" *0 -ue to the excess liquidity in the Nepalese market the money supply has been increased and the interest rate has been decreased. increases the price level. s the result, consumption and investment expenditure increase. This leads to an excessive increase in demand which

Re"u!* on n *'#'* on0 The low tax rate increases the purchasing power of people. 6ence, if the government reduces the tax rate so as to give relief to the people, the disposable income increases. &onsequently the consumption expenditure increases and inflation occurs. 6owever in case of Nepal the tax rate is consistent for a long period of time i.e. H T is :?>.

De) ! * ) n'n! n- o) *%e -o,ernmen*0 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. -eficit financing, therefore, leads to increasing money supply and hence is responsible for the price rise.

In!re'se n .r ,'*e e#.en" *ure0 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. s a result aggregate demand increases and inflation occurs.

S%or*'-e o) -oo"s 'n" ser, !es0 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.

In!re'se n .o.u&'* on0

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. B&'!< Mone:0 The existence of black money in Nepal due to corruption, tax evasion, gambling, etc. increases the aggregate demand. %eople spend much unearned money extravagantly, thereby creating unnecessary demand for commodities. This tends to raise the price level further.

(.2 COST/PUSH INFLATION

The 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 characteri3ed by fall in output, income and employment with the rise in price level. &ost!push inflation occurs due to increase in cost of production of goods and services in the economy. &ost!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 P2 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.

P1

P3

AS1

-ue to the increase in cost of production or supply constraints, the ( S) curve shifts leftward from S: to S7 to from %: to %7 to %? thereby leading to decline in output from y: to y?. leading to inflationary rise in price. The main causes of cost!push inflation are* In!re'se n ='-e r'*e0

ggregate Supply series of increase

S?. &onsequently, the prices increase

in cost of production will results in series of upward shift in aggregate supply curve

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.

Pro) *s0

+ith the motive of increasing profit, Nepalese entrepreneurs increase their profit margin level. Fntrepreneurs increase their profit by charging higher price for the commodity. s a result the cost of production increases and inflation occurs. In" re!* T'#es0 Increase in indirect taxes in Nepal like excise duty, custom duty increases the cost of living and push up the prices of products. Aor example, prices of consumer durables, like electronic goods, rise because of higher excise duty and increase the cost of production. Gikewise removal of government subsidies means the people have to pay full price or high price. Ho'r" n-0 6oarding of commodities, especially by the Nepalese traders by the traders for profiteering, is also responsible for rise in prices. -uring 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.

(.( E>CHANGE 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. +hen currency appreciates it will create upward pressure in general price level. round 98> of NepalDs import is from India. Ainally NepalDs import become costlier and price level in Nepal raises.

(.? 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. 6ence, 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 5%F&.

(.@ OTHER CAUSES

1. Consum.* on H'; *0 In general, the consumption habit of Nepal is more westerni3ed every day. In an economy where more than =@> of the population is below ?@ years of age, the younger generations are a way ahead in purchasing consumer durables and canned food items. 2. He',: T'# R'*e0 6eavy 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. 6ence increase the inflation. (. In!re's n- Fore -n Reser,e0 Increase in level of foreign currency reserve increases the broad money supply (#7). +hen money in agricultural lands have been degraded due to natural calamities. ?. B'n<s0 The number of bank and financial institution are increasing day by day. This helps to increase the credit availability to the general public. +hen credit availability increases, the general price level rises. @. Gro= n- !on!re*e Aun-&es0 t present time all we see around us are concrete buildings. Aertile 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.

B. H -% &';or !os*0 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. 5. Tr'ns.or*'* on !%'r-es0 Transport entrepreneurs have ganged up to overprice transportation costs because of rise in price of petroleum products. 6. Pr !e o) .e*ro&eum .ro"u!*s0 %rice of petroleum products has been ad$usted several times on the higher side. Such ad$ustments helped pushing the cost of freight and carriages and cost of other goods and services. C. Tr'nsm ss on *%rou-% *r'"e0 Aurthermore, rising inflation in India is transmitted in Nepal through trade, which is one of the significant factors of increasing inflation rate of Nepal. 13. Se'son'& !ons*r' n*s0 Seasonal constraints also prompted to push the inflation up in the past. Aor example, price rise on sugar and sugar.

In)&'* on Con*ro& Me'sures n Ne.'&

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. Mone*'r: Me'sures
#onetary policy aims at controlling the supply of money by influencing in availability and cost of bank money or bank credit. &entral bank entrusted with the task of enforcing the monetary policy. It is essential to adopt restrictive or dear monetary policy to combat inflation. .estrictive monetary policy is characteri3ed 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*

Du'n* *'* ,e Me'sures Luantitative measures aim at influencing the overall availability of bank credit and its cost. 5pen market operations, bank rate and legal reserve ratio are the main quantitative credit control measures. s 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. n 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.

nother 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. Se&e!* ,e !re" * !on*ro& me'sures Selective 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. 6owever, monetary policy is not very effective in curbing inflation, particularly in developing countries.

2. F s!'& me'sures
Aiscal policy also can be used to control inflation. Aiscal policy is the policy of the government revenue. &ontractionary fiscal policy policy can be used to reduce the aggregate demand and thereby control demand pull inflation. &ontractionary fiscal policy

is the policy of reducing government expenditure and increasing government revenue. The main tools of fiscal policy are* Pu;& ! e#.en" *ure %ublic 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. 6owever, 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. Aor example, expenditure on defense and unproductive works should be reduced.

T'#'* on The ma$or plank of anti! inflationary fiscal policy is to increase the tax burden by increasing the tax rate and by imposing new taxes. "ut direct and indirect taxes can be used for this purpose. -irect 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.

Pu;& ! ;orro= n%ublic borrowing enables the government to meet its expenditure and thereby reduces the need for deficit financing. #oreover, public borrowings help in reducing the amount of purchasing power and thereby total demand in the economy. 6owever, 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 governmentDs revenue producing a surplus budget is a type of fiscal policy which can be used to control inflation.

(. D re!* !on*ro& me'sures

9 Pr !e !on*ro& 'n" r'* on ndirect measure to control inflation is to introduce price controls and rationing of essential goods. 4nder 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. 4nder rationing a specified quantity of goods is given to the consumers at controlled price. %rice controls and rationing may be an effective policy in controlling inflation. 6owever, there are various practical difficulties in implementing this policy. Airstly, 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. "lack market is the market where goods are sold unlawfully at higher prices than the controlled price.

9 In!re's n- *%e ',' &'; & *: o) -oo"s 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*

%roduction should be increased. #ore specifically, production of inflation! sensitive goods need to be increased by allocating more resources, providing subsidies and removing bottlenecks impeding production of these goods.

-omestic production of essential goods may be supplemented by imports of these goods so as to reduce shortages and minimi3e inflationary pressures.

9 In"e#'* on Fconomists agree that if inflation is to be controlled, its adverse effects on different groups of the society should be minimi3ed. 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 ad$usting monetary incomes so as to minimi3e the undue gains or losses in real incomes of the different sections of the society due to inflation.