Money Supply and Inflation: Caiib Paper 1 (Module A), Unit 3

Money Supply and Inflation: Caiib Paper 1 (Module A), Unit 3

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So, here we are providing “Unit 3- Money Supply and Inflation” of “Module A: Economic Analysis” from “Paper 1: Advanced Bank Management (ABM)”.

The Article is Caiib Unit 3- Money Supply and Inflation

♦Money

Money is anything which performs the following four functions:

  • Medium of exchange: Individual goods and services; and other physical assets, are ‘priced’ in terms of money and are exchanged using money.
  • A measure of value: Money is used to measure and record the value of goods or services.
  • A store of value over time: Money can be held over a period of time and used to finance future payments.
  • Standard for deferred payments: Money is used as an agreed measure of future receipts and payments in contracts.
Money Supply
  • Money supply refers to the stoke of money available in the economy at a given point of time. Money supply date are recorded and published by the RBI on a fortnightly basis. Money supply affects the price level, exchange rates and business cycles in the economy. It may also affect the growth of GDP. The ratio between nominal GDP and money supply is called “Velocity of Money”.
Measures of Money supply

There are four common measures of Money supply, commonly used in India:

– Narrow Money (M1)= Currency with Public Demand Deposits with Banking System + ‘Other” Deposits with the RBI

– M2 = M1+ Savings deposits of Post Office Savings Banks

– M3 = M1+ Time Deposits with the Banking System

– M4 = M3+ All Deposits with post office savings banks (Excluding NSCs)

  • Currency with Public = Currency in circulation – Cash held by banks.
  • Demand Deposits include all liabilities which are payable on demand and they include current Deposits, demand liabilities portion of saving Banks Deposits, margins held Against LC/BG, Balance in OD FDs, Cash Certificates and Cumulative/RDs etc.
  • Time Deposits” are those which are payable otherwise than on demand and they include fixed Deposits, Cash Certificates, Cumulative and recurring Deposits, time Liabilities portion of savings bank deposits, etc.

♦Inflation

  • The concept of Inflation refers to a sustained rise in the general level of prices of goods and services in an economy over a period of time.
Causes of Inflation
  • Demand – pull Inflation: Demand – pull Inflation is a rise in general prices caused by increasing aggregate demand for goods and services.
  • Cost- Push Inflation: Cost- Push Inflation is a type of inflation caused by substantial increases in the cost of production of important goods of services, where no suitable alternative is available.
Measure of Inflation:       

Calculating inflation with Price Indexes

Inflation = (Price Index in Current Year–Price index in Base Year) X 100/Price index in Base Year

There are Important Price Indexes

  • Wholesale Price Index (WPI)
  • Consumer Price Index (CPI)
  • GDP Deflator

Wholesale Price Index (WPI)               

  • Wholesale Price Index, or WPI, measures the changes in the prices of goods sold and traded in bulk by wholesale businesses to other businesses. WPI is unlike the Consumer Price Index (CPI), which tracks the prices of goods and services purchased by consumers. What do you mean by the Wholesale Price Index? To put it simply, the WPI tracks prices at the factory gate before the retail level.

New series of WPI

  • With an aim to align the index with the base year of other important economic indicators such as GDP and IIP, the base year was updated to 2011-12 from 2004-05 for the new series of Wholesale Price Index (WPI), effective from April 2017.

How do you calculate Wholesale Price Index?

  • The monthly WPI number shows the average price changes of goods usually expressed in ratios or percentages.
  • The index is based on the wholesale prices of a few relevant commodities available.
  • The commodities are chosen based on their significance in the region. These represent different strata of the economy and are expected to provide a comprehensive WPI value.
  • The advanced base year 2011-12 adopted recently uses 697 items.

Consumer Price Index

  • Consumer Price Index or CPI as it is commonly called is an index measuring retail inflation in the economy by collecting the change in prices of most common goods and services used by consumers. Called market basket, CPI is calculated for a fixed list of items including food, housing, apparel, transportation, electronics, medical care, education, etc. Note that the price data is collected periodically, and thus, the CPI is used to calculate the inflation levels in an economy. This can be further used to compute the cost of living. This also provides insights as to how much a consumer can spend to be on par with the price change.
  • Remember, CPI is different from WPI, or Wholesale Price Index, which measures inflation at the wholesale level.

How is Consumer Price Index calculated?

  • The CPI is calculated with reference to a base year, which is used as a benchmark. The price change pertains to that year. Remember, when you calculate the CPI, note that the price of the basket in 1 year has to be first divided by the price of the market basket of the base year. Then, it is multiplied by 100.

Consumer Price Index formula:

  • CPI = (Cost of basket divided by Cost of basket in the base year) multiplied by 100
  • CPI’s annual percentage change is also used to assess inflation. In India, the base years of the current series of CPI(IW), CPI(AL) and CPI(RL), are 1982, 1986-87 and 1984-85, respectively.

GDP Deflator

  • GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy.

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