INTRODUCTION INFLATION is a rise in the general level of prices of goods and services in an economy over a period of time.

The term "inflation" once referred to increases in the money supply (monetary inflation); however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation. Inflation can also be described as a decline in the real value of moneya loss of purchasing power in the medium of e change which is also the monetary unit of account. !hen the general price level rises, each unit of currency buys fewer goods and services. " chief measure of price inflation is the inflation rate, which is the percentage change in a price inde over time. Inflation can cause adverse effects on the economy. #or e ample, uncertainty about future inflation may discourage investment and saving. $igh inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. It is generally agree that high rates of inflation and hyperinflation are caused by an e cessive growth of the money supply. %ow or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. $owever, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth. Today, most economists favor a low steady rate of inflation. %ow (as opposed to &ero or negative) inflation may reduce the severity of economic recessions by enabling the labor mar'et to ad(ust more )uic'ly in a downturn, and reducing the ris' that a li)uidity trap prevents monetary policy from stabili&ing the economy. The tas' of 'eeping the rate of inflation low and stable is usually given to monetary authorities. *enerally, these monetary authorities are the central ban's that control the si&e of the money supply through the setting of interest rates, through open mar'et operations, and through the setting of ban'ing reserve re)uirements.

CAUSES OF INFLATION There are a few different reasons that can account for the inflation in our goods and services; let+s very briefly review a few of them,

Demand-pull inflation refers to the idea that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until e)uilibrium is put in place between supply and demand.

The cost-push theor , also 'nown as "supply shoc' inflation", suggests that shortages or shoc's to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. .ou can readily see this in oil mar'ets. !hen /012 reduces oil supply, prices are artificially driven up and result in higher prices at the pump.

!one suppl plays a large role in inflationary pressure as well. 3onetarist economists believe that if the #ederal 4eserve does not control the money supply ade)uately, it may actually grow at a rate faster than that of the potential output in the economy, or real *50. The belief is that this will drive up prices and hence, inflation. %ow interest rates correspond with a high level of money supply and allow for more investment in big business and new ideas which eventually leads to unsustainable levels of inflation as cheap money is available. The credit crisis of 6778 is a very good e ample of this at wor'.

Inflation can artificially be created through a circular increase in wage earners demands and then the subse)uent increase in producer costs which will drive up the prices of their goods and services. This will then translate bac' into higher prices for the wage earners or consumers. "s demands go higher from each side, inflation will continue to rise.

EFFECTS OF INFLATION 9ome effects that inflation can have on an economy, The effects of inflation can be brutal for the elderly who are loo'ing to retire on a fi ed income. The dollars that they e pect to retire with will be worth less and less as time goes on and inflation goes higher.

!hen the balance between supply and demand spirals out of control, buyers will change their spending habits as they meet their purchasing thresholds and producers will suffer and be forced to cut output. This can be readily tied to higher unemployment rates. !hen e tremes arise in the supply:demand structure, imbalances are created.

The mortgage crisis of 6778 is a great e ample of this. $ome prices were increasing at a very rapid rate from 6776 to 677; and got to the point where the prices became too high, forcing buyers to step aside. This lac' of demand forced sellers to drop prices bac' to a point where there is demand. "s I write this article, this e)uilibrium has still not come into the real estate mar'et. This is due to many factors, as you will read in our mortgage crisis article, but the e treme acceleration of inflation in home prices is directly correlated to the pullbac' we are seeing. " similar e ample can be seen in the internet euphoria in the stoc' mar'et bac' in <==> to 6777. This rapid acceleration in stoc' prices eventually became unsustainable and led to a disastrous fall. The point that is "ein# made is that if inflation is not contained and rises at an unsustaina"le rate$ the stron#er %ill "e the impact on the other side& There is a sa in#$ 'the "i##er the are( the harder the fall'&

!EASURES Inflation is usually measured by calculating the inflation rate of a price inde , usually the 2onsumer 0rice Inde . The 2onsumer 0rice Inde measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price inde over time. /ther widely used price indices for calculating price inflation include the following,

Cost-of-li)in# indices (2/%I) are indices similar to the 20I which are often used to ad(ust fi ed incomes and contractual incomes to maintain the real value of those incomes. *roducer price indices (00Is) which measures average changes in prices received by domestic producers for their output. This differs from the 20I in that price subsidi&ation, profits, and ta es 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 00I and any eventual increase in the 20I. 0roducer price inde 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. In India and the ?nited 9tates, an earlier version of the 00I was called the !holesale 0rice Inde .

Commodit price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee. Core price indices, because food and oil prices can change )uic'ly due to changes in supply and demand conditions in the food and oil mar'ets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of +core inflation+, which removes the most volatile components (such as food and oil) from a broad price inde li'e the 20I. @ecause core inflation is less affected by short run supply and demand conditions in specific mar'ets, central ban's rely on it to better measure the inflationary impact of current monetary policy.

/ther common measures of inflation are,

+D* deflator is a measure of the price of all the goods and services included in *ross 5omestic 0roduct (*50). The ?9 2ommerce 5epartment publishes a deflator series for ?9 *50, defined as its nominal *50 measure divided by its real *50 measure. Re#ional inflation The @ureau of %abor 9tatistics brea's down 20I-? calculations down to different regions of the ?9. ,istorical inflation @efore collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. 3ost inflation data before the early 67th century is imputed based on the 'nown costs of goods, rather than compiled at the time. It is also used to ad(ust for the differences in real standard of living for the presence of technology. Asset price inflation is an undue increase in the prices of real or financial assets, such as stoc'(e)uity) and real estate. 9ome central ban'ers have suggested that it would be better to aim at stabili&ing a wider general price level inflation measure that includes some asset prices, instead of stabili&ing 20I or core inflation only.

!ONETAR- *OLIC-

!onetar polic is the process by which the government, central ban', or monetary authority of a country controls .i/ The suppl of mone ( .ii/ A)aila"ilit of mone ( and .iii/ Cost of mone or rate of interest( 3onetary policy is referred to as either being an e pansionary policy, or a contractionary policy, where an e pansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. 1 pansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. 3onetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. 3onetary policy uses a variety of tools to control one or both of these, to influence outcomes li'e economic growth, inflation, e change rates with other currencies and unemployment. !here currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through ban's which are tied to a central ban', the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals).

" policy is referred to as Contractionar if it reduces the si&e of money supply or raises the interest rate. "n E0pansionar policy increases the money supply or decreases the interest rate. #urthermore, monetary policies are described as follows, Accommodati)e, if the interest rate set by the central monetary authority is intended to create economic growth; Neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. The primar tool of monetar polic is open mar1et operations. This entails managing the )uantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. "ll of these purchases or sales result in more or less base currency entering or leaving mar'et circulation. ?sually, the short term goal of open mar'et operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific e change rate relative to some foreign currency or else relative to gold The other primary means of conducting monetary policy include, .i/ .ii/ .iii/ .i)/ Discount %indo% lendin# (lender of last resort); Fractional deposit lendin# (changes in the reserve re)uirement); !oral suasion (ca(oling certain mar'et players to achieve specified outcomes); 'Open mouth operations' (tal'ing monetary policy with the mar'et).

,ISTOR- OF !ONETAR- *OLIC3onetary policy is primarily associated with interest rate and credit. #or many centuries there were only two forms of monetary policy, (i) 5ecisions about coinage; (ii) 5ecisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. 3onetary policy was seen as an e ecutive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. !ith the advent of larger trading networ's came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the mar'et price. !ith the creation of the @an' of 1ngland in <A=B, which ac)uired the responsibility to print notes and bac' them with gold, the idea of monetary policy as independent of e ecutive action began to be established. The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central ban's by industriali&ing nations was associated then with the desire to maintain the nation+s peg to the gold standard, and to trade in a narrow band with other gold-bac'ed currencies. To accomplish this end, central ban's as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other ban's that re)uired li)uidity. The maintenance of a gold standard re)uired almost monthly ad(ustments of interest rates. 5uring the <>87-<=67 period the industriali&ed nations set up central ban'ing systems, with one of the last being the #ederal 4eserve in <=<C. @y this point the role of the central ban' as the "lender of last resort" was understood.

It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which focused on how many more, or how many fewer, people would ma'e a decision based on a change in the economic trade-offs. It also became clear that there was a business cycle, and economic theory began understanding the relationship of interest rates to that cycle. (Devertheless, steering a whole economy by influencing the interest rate has often been described as trying to steer an oil tan'er with a canoe paddle.) 4esearch by 2ass @usiness 9chool has also suggested that perhaps it is the central ban' policies of e pansionary and contractionary policies that are causing the economic cycle; evidence can be found by loo'ing at the lac' of cycles in economies before central ban'ing policies e isted. The advancement of monetary policy as a pseudo scientific discipline has been )uite rapid in the last <;7 years, and it has increased especially rapidly in the last ;7 years. 3onetary policy has grown from simply increasing the monetary supply enough to 'eep up with both population growth and economic activity. It must now take into account such diverse factors as:

short term interest rates; long term interest rates; velocity of money through the economy; exchange rates; credit quality; bonds and equities (corporate ownership and debt); government versus private sector spending/savings; international capital flows of money on large scales; financial derivatives such as options swaps futures contracts etc!

TRENDS IN CETRAL 2AN3IN+ The central ban' influences interest rates by e panding or contracting the monetary base, which consists of currency in circulation and ban's+ reserves on deposit at the central ban'. The primary way that the central ban' can affect the monetary base is by open mar'et operations or sales and purchases of second hand government debt, or by changing the reserve re)uirements. If the central ban' wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting ban's+ reserve accounts. "lternatively, it can lower the interest rate on discounts or overdrafts (loans to ban's secured by suitable collateral, specified by the central ban'). If the interest rate on such transactions is sufficiently low, commercial ban's can borrow from the central ban' to meet reserve re)uirements and use the additional li)uidity to e pand their balance sheets, increasing the credit available to the economy. %owering reserve re)uirements has a similar effect, freeing up funds for ban's to increase loans or buy other profitable assets. " central ban' can only operate a truly independent monetary policy when the e change rate is floating. If the e change rate is pegged or managed in any way, the central ban' will have to purchase or sell foreign e change. These transactions in foreign e change will have an effect on the monetary base analogous to open mar'et purchases and sales of government debt; if the central ban' buys foreign e change, the monetary base e pands, and vice versa. @ut even in the case of a pure floating e change rate, central ban's and monetary authorities can at best "lean against the wind" in a world where capital is mobile.

"ccordingly, the management of the e change rate will influence domestic monetary conditions. In order to maintain its monetary policy target, the central ban' will have to sterili&e or offset its foreign e change operations. #or e ample, if a central ban' buys foreign e change (to counteract appreciation of the e change rate), base money will increase. Therefore, to sterili&e that increase, the central ban' must also sell government debt to contract the monetary base by an e)ual amount. It follows that turbulent activity in foreign e change mar'ets can cause a central ban' to lose control of domestic monetary policy when it is also managing the e change rate. In the <=>7s, many economists began to believe that ma'ing a nation+s central ban' independent of the rest of e ecutive government is the best way to ensure an optimal monetary policy, and those central ban's which did not have independence began to gain it. This is to avoid overt manipulation of the tools of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy have long, fi ed terms. /bviously, this is a somewhat limited independence. In the <==7s, central ban's began adopting formal, public inflation targets with the goal of ma'ing the outcomes, if not the process, of monetary policy more transparent. In other words, a central ban' may have an inflation target of 6E for a given year, and if inflation turns out to be ;E, then the central ban' will typically have to submit an e planation. The @an' of 1ngland e emplifies both these trends. It became independent of government through the @an' of 1ngland "ct <==> and adopted an inflation target of 6.;E 40I (now 6E of 20I).

T-*ES OF !ONETAR- *OLICIES In practice, all types of monetary policy involve modifying the amount of base currency (37) in circulation. This process of changing the li)uidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open mar'et operations. 2onstant mar'et transactions by the monetary authority modify the supply of currency and this impacts other mar'et variables such as short term interest rates and the e change rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Inflation Targeting Price Level Targeting Monetary Aggregates

Target Market Variable: Interest rate on overnight debt Interest rate on overnight debt

Long Term Objective: A given rate of change in the CPI A specific CPI number

The growth in money A given rate of change in the supply CPI

Fixed xchange The spot price of the !ate The spot price of the currency currency "old #tandard The spot price of gold Mixed Policy Low inflation as measured by the gold price

$sually interest rates $sually unemployment % CPI

change The different types of policy are also called monetar re#imes, in parallel to e change rate regimes. " fi ed e change rate is also an e change rate regime; The *old standard results in a relatively fi ed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating e change rate unless the management of the relevant foreign currencies is trac'ing the e act same variables (such as a harmoni&ed consumer price inde ). Inflation tar#etin# ?nder this policy approach the target is to 'eep inflation, under a particular definition such as 2onsumer 0rice Inde , within a desired range.

The inflation target is achieved through periodic ad(ustments to the 2entral @an' interest rate target. The interest rate used is generally the interban' rate at which ban's lend to each other overnight for cash flow purposes. 5epending on

the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open mar'et operations. Typically the duration that the interest rate target is 'ept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or )uarterly basis by a policy committee. 2hanges to the interest rate target are made in response to various mar'et indicators in an attempt to forecast economic trends and in so doing 'eep the mar'et on trac' towards achieving the defined inflation target. #or e ample, one simple method of inflation targeting called the Taylor rule ad(usts the interest rate in response to changes in the inflation rate and the output gap. The inflation targeting approach to monetary policy approach was pioneered in Dew Fealand. It is currently used in "ustralia, 2anada, 2hile, DewFealand, Dorway, Iceland, 0hilippines,0oland, 9weden, 9outh "frica, Tur'ey, and the ? G. *rice le)el tar#etin# 0rice level targeting is similar to inflation targeting e cept that 20I growth in one year is offset in subse)uent years such that over time the price level on aggregate does not move. 9omething similar to price level targeting was tried by 9weden in the <=C7s, and seems to have contributed to the relatively good performance of the 9wedish economy during the *reat 5epression. "s of 677B, no country operates monetary policy based on a price level target.

!onetar a##re#ates In the <=>7s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (37, 3< etc). In the ?9" this approach to monetary policy was discontinued with the selection of "lan *reenspan as #ed 2hairman.

This approach is also sometimes called monetarism. !hile most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary )uantities.

Fi0ed e0chan#e rate This policy is based on maintaining a fi ed e change rate with a foreign currency. There are varying degrees of fi ed e change rates, which can be ran'ed in relation to how rigid the fi ed e change rate is with the anchor nation.

+old standard The gold standard is a system in which the price of the national currency as measured in units of gold bars and is 'ept constant by the daily buying and selling of base currency to other countries and nationals. (i.e. open mar'et operations, cf. above). The selling of gold is very important for economic growth and stability.

!ONETAR- *OLIC- TOOLS

!onetar "ase 3onetary policy can be implemented by changing the si&e of the monetary base. This directly changes the total amount of money circulating in the economy. " central ban' can use open mar'et operations to change the monetary base. The central ban' would buy:sell bonds in e change for hard currency. !hen the central ban' disburses:collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base. Reser)e re4uirements The monetary authority e erts regulatory control over ban's. 3onetary policy can be implemented by changing the proportion of total assets that ban's must hold in reserve with the central ban'. @an's only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illi)uid assets li'e mortgages and loans. @y changing the proportion of total assets to be held as li)uid cash, the #ederal 4eserve changes the availability of loanable funds. This acts as a change in the money supply. Discount %indo% lendin# 3any central ban's or finance ministries have the authority to lend funds to financial institutions within their country. @y calling in e isting loans or e tending new loans, the monetary authority can directly change the si&e of the money supply.

Interest rates The contraction of the monetary supply can be achieved indirectly by

increasing the nominal interest rates. 3onetary authorities in different nations have differing levels of control of economy-wide interest rates. In the ?nited 9tates, the #ederal 4eserve can set the discount rate, as well as achieve the desired #ederal funds rate by open mar'et operations. This rate has significant effect on other mar'et interest rates, but there is no perfect relationship @y raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. @oth of these effects reduce the si&e of the money supply. Currenc 2oard " currency board is a monetary arrangement which pegs the monetary base of a country to that of an anchor nation. "s such, it essentially operates as a hard fi ed e change rate, whereby local currency in circulation is bac'ed by foreign currency from the anchor nation at a fi ed rate. Thus, to grow the local monetary base an e)uivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other ob(ectives.The principal rationales behind a currency board are three-fold, (i) To import monetary credibility of the anchor nation; (ii) To maintain a fi ed e change rate with the anchor nation; (iii) To establish credibility with the e change rate (the currency board arrangement is the hardest form of fi ed e change rates outside of dollari&ation). FI5ED E5C,AN+E RATE " fi0ed e0chan#e rate, sometimes called a pe##ed e0chan#e rate, is a type of e change rate regime wherein a currency+s value is matched to the value of another single currency or to a bas'et of other currencies, or to another measure of value, such as gold. " fi ed e change rate is usually used to stabili&e the value of a currency, vis-avis the currency it is pegged to.

This facilitates trade and investments between the two countries, and is especially useful for small economies where e ternal trade forms a large part of their *50. It is also used as a means to control inflation. $owever, as the reference value rises and falls, so does the currency pegged to it. In addition, a fi ed e change rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. In certain situations, fi ed e change rates may be preferable for their greater stability. #or e ample, the "sian financial crisis was improved by the fi ed e change rate of the 2hinese renminbi, and the I3# and the !orld @an' now ac'nowledge that 3alaysia+s adoption of a peg to the ?9 dollar in the aftermath of the same crisis was highly successful. #ollowing the devastation of !orld !ar II, the @retton !oods system allowed all the BB "llied nations of latter !orld !ar II to have fi ed e change rates until <=87 with the ?9 dollar. !ith regard to the "sian financial crisis, others argue that the fi ed e change rates (implemented well before the crisis) had become so immovable that it had mas'ed valuable information needed for a mar'et to function properly. That is, the currencies did not represent their true mar'et value. This mas'ing of information created volatility which encouraged speculators to "attac'" the pegged currencies and as a response these countries attempted to defend their currency rather than allow it to devalue. These economists also believe that had these countries instituted floating e change rates, as opposed to fi ed e change rates, they may very well have avoided the volatility that caused the "sian financial crisis in the first place. 2ountries adopting a fi ed e change rate must e ercise careful and strict adherence to policy imperatives, and 'eep a degree of confidence of the capital mar'ets in the management of such a regime, or otherwise the peg can fail.

9uch was the case of "rgentina, where unchec'ed state spending and international economic shoc's misbalanced the system and ended up forcing an e tremely damaging devaluation . !aintainin# a fi0ed e0chan#e rate Typically, a government wanting to maintain a fi ed e change rate does so by either buying or selling its own currency on the open mar'et. This is one reason governments maintain reserves of foreign currencies. If the e change rate drifts too far below the desired rate, the government buys its own currency off the mar'et using its reserves. This places greater demand on the mar'et and pushes up the price of the currency. If the e change rate drifts too far above the desired rate, the opposite measures are ta'en. "nother, less used means of maintaining a fi ed e change rate is by simply ma'ing it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a blac' mar'et in foreign currency. Donetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This is the method employed by the 2hinese government to maintain a currency peg or tightly banded float against the ?9 dollar. Throughout the <==7s, 2hina was highly successful at maintaining a currency peg using a government monopoly over all currency conversion between the yuan and other currencies.

!undell Flemmin#6s e0ample of Fi0ed E0chan#e Rate

CRITICIS! The main criticism of a fi ed e change rate is that fle ible e change rates serve to automatically ad(ust the balance of trade. !hen a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn ma'es the price of foreign goods less attractive to the domestic mar'et and thus pushes down the trade deficit. ?nder fi ed e change rates, this automatic re-balancing does not occur.

FI5ED E5C,AN+E 78S CA*ITAL CONTROL ?sual belief that the fi ed e change rate regime brings with stability is a misconception. "lmost all speculative attac's are targeted on currencies with fi ed e change rate regime, and in fact, the stability of the economy system is mainly due to 2apital control.

The fi ed e change rate regime should be viewed as a tool to ensure the capital mobility control. #or instance, 2hina allows freely e change for current account transactions since 5ecember <, <==A. In more than B7 categories of capital account, there are about 67 of them are under control. @ecause of the capital control, even renminbi is not under the managed floating e change rate regime (but a clean floating), it will be useless for foreigners to get renminbi. 9o it is not about the e change rate regime that matters for the dynamics of balance of payment, but the capital control.

+OLD STANDARD

?nder a gold standard, paper notes are convertible into pre-set, fi ed )uantities of gold. The gold standard is a monetary system in which a region+s common media of e change are paper notes that are normally freely convertible into pre-set, fi ed )uantities of gold. The standard specifies how the gold bac'ing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the e)uivalent specie. " ?.9. silver certificate, for e ample, could be redeemed for an actual piece of silver. *old was a common form of representative money due to its rarity, durability, divisibility, fungibility, and ease of identification. The histor of mone consists of three phases9 2ommodity money, in which actual valuable ob(ects are bartered; then 4epresentative money, in which paper notes (often called +certificates+) are used to represent real commodities stored elsewhere; and #iat money, in which paper notes are bac'ed only by use of+ "lawful force and legal tender laws" of the government, in particular by its acceptability for payments of debts to the government (usually ta es). 2ommodity money is inconvenient to store and transport. It also does not allow the government to control or regulate the flow of commerce within their dominion with the same ease that a standardi&ed currency does. "s such, commodity money gave way to representative money, and gold and other specie were retained as its bac'ing. The *old 9tandard variously specified how the gold bac'ing would be implemented, including the amount of specie per currency unit. The currency itself is (ust paper and so has no innate value, but is accepted by traders because it can be redeemed any time for the e)uivalent specie. .

Esta"lishment of the international #old standard !hen *ermany became a unified country following the #ranco-0russian !ar (<= Huly <>87 I <7 3ay <>8<), it established the mar' and defined its value in gold. 3ost other nations )uic'ly followed suit. *old became a transportable, universal and stable unit of valuation. The world+s dominant economy at the time, the ?nited Gingdom, already had a longstanding commitment to the gold standard. The main purpose of either government money system has historically been to provide seigniorage, or money-creation profit, to governmental leaders in order to provide them with general purchasing power during emergencies, especially those leaders who are legislatively constrained and therefore unable to raise ta es in order to e ecute the defense commitments that are re)uired for the survival of their states. *old standards replaced gold-coin standards in the <8th-<=th centuries in the !est as the e tent of defensive warfare e panded to where the gold-coin standards were no longer sufficient to the tas'. " similar history generated a gold standard in 2hina from the =th through the early <8th century. Dates of adoption of a #old standard

1717: United Kingdom at 1 to 113 grains (7.32 g) of fine gold. 1818: Netherlands at 1 guilder to 0.60 61 g gold. 183!: United "tates de facto at 20.67 dollars to 1 tro# o$ (31.1 g) gold 18 !: %ortugal at 1000 r&is to 1.62 8 g gold. 1871: 'erman# at 27(0 'oldmar)s to 1 )g gold. 1871: *a+an at 1 #en to 1. g gold. 1873: ,atin -onetar# Union (.elgium/ 0tal#/ "1it$erland/ 2ran3e) at 31 fran3s to (.0 g gold 187 : "3andina4ian monetar# union: (5enmar)/ Nor1a# and "1eden) at 2!80 )roner to 1 )g gold. 1876: 2ran3e internall#.

1876: "+ain at 31 +esetas to (.0 g gold. 1878: 2inland at 31 mar)s to (.0 g gold. 187(: 6ustria. 1881: 6rgentina at 1 +eso to 1.! 16 g gold. 18(3: 7ussia at 31 ru8les to 2!.0 g gold. 18(7: *a+an at 1 #en de4alued to 0.7 g gold. 18(8: 0ndia. 1(00: United "tates.

Ad)anta#es The theory of the gold standard rests on the idea that ma imal increases in governmental purchasing power during wartime emergencies re)uire post-war deflations, which would not occur without monetary institutions li'e the gold standard, which insist upon return to pre-war price-levels and therefore deflationary wartime e pectations. The gold standard limits the power of governments to inflate prices through e cessive issuance of paper currency. It may tend to reduce uncertainty in international trade by providing a fi ed pattern of international e change rates. ?nder the classical international gold standard, disturbances in price levels in one country would be partly or wholly offset by an automatic balance-of-payment ad(ustment mechanism called the "price specie flow mechanism."

Disad)anta#es

The total amount of gold that has ever been mined has been estimated at around <B6,777 tonnes. "ssuming a gold price of ?9J<,777 per ounce, or JC6,;77 per 'ilogram, the total value of all the gold ever mined would be around JB.; trillion. This is less than the value of circulating money in the ?.9. alone, where more than J8.A trillion is in circulation or in deposit (although international ban'ing currently practices fractional

reserves). Therefore, a return to the gold standard would result in a significant increase in the current value of gold, which may limit its use in current applications. #or e ample, instead of using the ratio of J<,777 per ounce, the ratio can be defined as J6,777 per ounce (or J<,777 per <:6 ounce) effectively raising the value of gold to J> trillion. $owever, this is specifically a perceived disadvantage of return to the gold standard and not the efficacy of the gold standard itself. *old standard advocates consider this to be both acceptable and necessary.

3ost mainstream economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns. #ollowing a gold standard would mean that the amount of money would be determined by the supply of gold, and hence monetary policy could no longer be used to stabili&e the economy in times of economic recession. This would cause economic recessions to be longer and deeper than is currently the case.

INCO!E *OLICIES Incomes policies vary from "voluntary" wage and price guidelines to mandatory controls li'e price:wage free&es. /ne variant is "ta -based incomes policies" (TI0s), where a government fee is imposed on those firms that raise prices and:or wages more than the controls allow. This is seen as internali&ing the

e ternal cost of raising prices and:or wages, solving a mar'et failure that encourages inflation. 9ome economists agree that a credible incomes policy would help prevent inflation. $owever, this would have other effects. @y arbitrarily interfering with price signals, they provide an additional bar to achieving economic efficiency, potentially leading to shortages and declines in the )uality of goods on the mar'et, while re)uiring large government bureaucracies for their enforcement. This is what happened in the ?nited 9tates during the early <=87s. !hen the price of a good is lowered artificially, it creates less supply and more demand for the product, thereby creating shortages. 9ome economists argue that incomes policies are less e pensive (more efficient) than recessions as a way of fighting inflation, at least for mild inflation. .et others argue that controls and mild recessions can be complementary solutions for relatively mild inflation. The policy has the best chance of being credible and effective for those sectors of the economy dominated by monopolies or oligopolies, particularly nationalised industry, with a significant sector of wor'ers organi&ed in labor unions. These institutions enable collective negotiation and monitoring of the wage and price agreements. /ther economists argue that inflation is essentially a monetary phenomenon, and the only way to deal with it is by controlling the money supply, either directly or by means of interest rates. They argue that price inflation is only a symptom of previous monetary inflation caused by central ban' money creation. This view holds that without a totally planned economy the incomes policy can never wor', because the e cess money in the economy will greatly distort areas which the incomes policy does not cover. !age and price controls have been successful in wartime environments in combination with rationing. $owever, their use in other conte ts is far more mi ed. Dotable failures of their use include the <=86 imposition of wage and price controls by 4ichard Di on. 3ore successful e amples include the 0rices and Incomes "ccord in "ustralia and the !assenaar "greement in the Detherlands.

In general wage and price controls are regarded as a temporary and e ceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for e ample, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the mar'et. "rtificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is over consumed. #or e ample, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread ma'ing by the mar'et to satisfy future needs, thereby e acerbating the problem in the long term. Temporary controls may complement a recession as a way to fight inflation, the controls ma'e the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the 'inds of distortions that controls cause when demand is high. $owever, in general the advice of economists is not to impose price controls but to liberali&e prices by assuming that the economy will ad(ust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed.

FISCAL *OLICFiscal polic is the use of government spending and revenue collection to influence the economy.

#iscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabili&e the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and ta ation. 2hanges in the level and composition of ta ation and government spending can impact on the following variables in the economy,

"ggregate demand and the level of economic activity; The pattern of resource allocation; The distribution of income.

T-*ES OF FISCAL *OLICIES #iscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, e pansionary and contractionary,

A neutral stance of fiscal polic implies a balanced budget where * K T (*overnment spending K Ta revenue). *overnment spending is fully funded by ta revenue and overall the budget outcome has a neutral effect on the level of economic activity. An e0pansionar stance of fiscal polic involves a net increase in government spending (* L T) through rises in government spending or a fall in ta ation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. 1 pansionary fiscal policy is usually associated with a budget deficit. A contractionar fiscal polic (* M T) occurs when net government spending is reduced either through higher ta ation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. 2ontractionary fiscal policy is usually associated with a surplus.

#iscal policy was invented by Hohn 3aynard Geynes in the <=C7s.

!ethods of Fundin# *overnments spend money on a wide variety of things, from the military and police to services li'e education and healthcare, as well as transfer payments such as welfare benefits. This e penditure can be funded in a number of different ways,

Ta ation 9eignorage, the benefit from printing money @orrowing money from the population, resulting in a fiscal deficit. 2onsumption of fiscal reserves. 9ale of assets (e.g., land).

Fundin# the deficit " fiscal deficit is often funded by issuing bonds, li'e treasury bills or consoles. These pay interest, either for a fi ed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors. 9ome peculiarities e ist, for e ample, the ?9 owes most of its own debt to itself. Consumin# the surplus " fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. !hen income from ta ation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring a deficit.

Economic effects of fiscal polic

#iscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic ob(ectives of price stability, full employment and economic growth. Geynesian economics suggests that ad(usting government spending and ta rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framewor' for strong economic growth and wor'ing toward full employment. The government can implement these deficit-spending policies due to its si&e and prestige and stimulate trade. 5uring periods of high economic growth, a budget surplus can be used to decrease activity in the economy. " budget surplus will be implemented in the economy if inflation is high, in order to achieve the ob(ective of price stability. The removal of funds from the economy will, by Geynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability. 9ome classical and neoclassical economists argue that fiscal policy can have no stimulus effect; this is 'nown as the Treasury Niew, and categorically re(ected by Geynesian economics. The Treasury Niew refers to the theoretical positions of classical economists in the @ritish Treasury who opposed Geynes call for fiscal stimulus in the <=C7s.

#rom their point of view, when government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. !hen governments fund a deficit with the release of government bonds, an increase in interest rates across the mar'et can occur. This is because government borrowing creates higher demand for credit in the financial mar'ets, causing a lower aggregate demand ("5), contrary to the ob(ective of a budget deficit. This concept is called crowding out.

/ther possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy and inflationary effects driven by increased demand. #iscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. #or instance, if a fiscal stimulus employs a wor'er who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a wor'er who otherwise would have had a (ob, the stimulus is increasing demand.

#I92"% 0/%I2.-?G 12/D/3.

!/4%5 ID#%"TI/D 4"T1 I 6778

JERRY THOMAS 4854 BAPPI BARMAN 4866

INDEX
"cknowledgement #b$ectives Introduction
%! inflation &! causes '! effects (! origins )! measures

%! &! '! (!

*onetary policy
introduction history types of monetary policy monetary policy tools

fixed exchange rate gold standard income policies fiscal policies

%! introduction &! types '! economic effects of fiscal policy

conclusion references

references

www!wikikipedia!com www!google!com www!yahoo!com

ACKNOWLEDGEME NT
!1 !/?%5 %IG1 T/ 1OT1D5 " N/T1 /# T$"DG9 T/ #/%%/!ID* 01/0%1 !$/91 *?I5"D21, $1%0 "D5 9?00/4T $1%015 I331D9%. ID T$1 TI31%. 2/30%1TI/D /# T$1 04/H12T 349. 9$"%IDI 04"G"9$ !hose support has guided us to the completion of this pro(ect. $er invaluable inputs, in class P otherwise, made the tas' much easier on our shoulders.

/?4 #"3"%I19 !ho co-operated with us and allowed us to occupy the computer at given momentQs notices, so that we could meet our deadlines.

CONCLUSION
Controlling Inflation forms a significant part of the economic activities of a nation. Inflation is an economic condition characterized by a general rise in the prices. Thus, controlling Inflation is important as unrestrained increase of the prices may culminate in Hyperinflation, and an excessive fall in the prices may lead to Deflation. Both the situations are not healthy and sound for the overall gro th and development of a country!s economy. In fact, "eeping a strong control over Inflation has turned out to be one of the primary ob#ectives of the governments of different countries across the globe. To this effect, efficacious economic policies are being formulated, hich mainly concentrate on the fundamental causes of Inflation in an economy, and try to improvise methods to "eep the inflationary conditions under control.

$or instance, if the primary reason for inflation in a nation is the excessive demand for goods and services, then the economic policy on governmental level should find out the causes of such unnecessary rise and underta"e measures to decrease the overall level of collective demand. %ometimes, if it is seen that Cost&'ush Inflation is responsible for the rise in the demand for goods and services, then the cost of production must be chec"ed, to handle the inflation&related problems. Methods which have proved to be highly effective in controlling inflation to large extents are:-

Fiscal Policies:
$iscal policies are effective in increasing the lea"age rates from the circular income flo , thereby re#ecting all further additions into this particular flo of income. This brings about a reduction in the Demand&'ull Inflation, in terms of increasing unemployment and slac"ening the economic gro ths. $ollo ing are a fe types of fiscal policies commonly employed( )o ering the expenses on governmental level * fall in the borro ing amounts in the government sectors, on an annual basis High direct taxes, for reducing the disposable income

Monetary Policies:
These are policies hich can actually control the rise in demand, by increasing the rates of interest and reducing the supply of real money. *n escalation in the interest rates brings about a reduction in collective demands, in the follo ing three ays(

* rise in the interest rate discourages borro ing from both companies and households. +hen interest rates increase, it simultaneously encourages the savings rate, o ing to an escalation in the opportunity cost of expenditure. ,ise in the interest rates is a very useful tool for restricting monetary inflation. Increase in the real rates of interest decreases the demand for loans, thereby limiting the gro th of broad money. There may also be a fall in the commercial investments, due to a rise in the costs of borro ing money. This exerts a direct influence on a handful of planned investment&related pro#ects, hich turn out to be unprofitable. This leads to a fall in the collective demand. *n increase in the payment of mortgage interests automatically decreases the real !effective! disposable income of the house o ners, as ell as their spending capacities. -scalation in the mortgage costs also decreases the demand generated in the housing mar"ets.

Income policies or direct wage controls %etting restrictions on the gro th rate of ages may decrease cost push inflation. .n governmental level, an attempt to influence the gro th of age leads to limit the rise in the pay in public sectors, as ell as initiates cash restrictions for ma"ing payments to the employees of public sectors. Gold standard The gold standard is a monetary system in hich a region!s common media of exchange are paper notes that are normally freely convertible into pre&set, fixed /uantities of gold.

The gold standard limits the po er of governments to inflate prices through excessive issuance of paper currency. 0nder the classical international gold standard, disturbances in price levels in one country ould be partly or holly offset by an automatic balance&of&payment ad#ustment mechanism called the 1price specie flo mechanism.1

Objectives
+o study the measures to control inflation and their working, *onetary policy -ixed exchange rate .old standard Income policies -iscal policies