PROJECT REPORT

ON

SUBMITTED BY
Usman Ghani CS/09/9124
Institute of Engineering and Technology, Bhaddal
usman.ghani599@gmail.com
usman.ghani@live.in
 ACKNOWLEDGEMENT

I am grateful to my teacher Mr. Mujahid who guided us during the

difficult moments; we faced during the completion of this project.

This project would not have been completed if our teacher had not

helped us in selecting critical matter related to the project from various

books.

Usman Ghani CS/09/9124

Contents

 1 Introduction
 2 Government intervention
o 2.1 State planning
o 2.2 Mixed economy
o 2.3 Public expenditure
o 2.4 Public receipts
o 2.5 General budget
 3 Currency System
o 3.1 Rupee
o 3.2 Exchange rates
 4 Determinants
o 4.1 Demographics
o 4.2 Geography and natural resources
o 4.3 Physical infrastructure
o 4.4 Politics
o 4.5 Financial institutions
 5 Sectors
o 5.1 Agriculture
o 5.2 Industry
o 5.3 Services
o 5.4 Banking and finance
 6 Socio-economic characteristics
o 6.1 Poverty
o 6.2 Corruption
o 6.3 Inflation
Economy of India
The economy of India is the fourth-largest in the world as measured by purchasing power parity
(PPP), with a GDP of US $3.36 trillion. When measured in USD exchange-rate terms, it is the
tenth largest in the world, with a GDP of US $691.87 billion (2004). India was the second fastest
growing major economy in the world, with a GDP growth rate of 8.1% at the end of the first
quarter of 2005–2006. However, India's huge population results in a relatively low per capita
income of $3,100 at PPP. The country's economy is diverse and encompasses agriculture,
handicrafts, industries and a multitude of services. Services are the major source of economic
growth in India today, though two-thirds of the Indian workforce earns their livelihood directly
or indirectly through agriculture. In recent times, India has also capitalized on its large number of
highly educated people who are fluent in the English language to become a major exporter of
software services, financial services and software engineers.

India has adhered to a socialist-inspired approach for most of its independent history, with strict
government control over private sector participation, foreign trade, and foreign direct investment.
Since the early 1990s, India has gradually opened up its markets through economic reforms by
reducing government controls on foreign trade and investment. Privatization of public-owned
industries and opening up of certain sectors to private and foreign players has proceeded slowly
amid political debate.

The socio-economic problems India faces are a burgeoning population and lack of infrastructure,
as well as growing inequality and unemployment. Poverty also remains a problem although it has
seen a decrease of 10% since the 1980s.

Government intervention

State planning

The economy of India is based in part on planning through its five-year plans, developed,
executed and monitored by the Planning Commission. With the Prime Minister as the ex officio
Chairman, the commission has a nominated Deputy Chairman, who has rank of a Cabinet
minister. Montek Singh Ahluwalia is currently the Deputy Chairman of the Commission. The
tenth plan completed its term in March 2007 and the eleventh plan is currently underway.

Eleventh plan (2007-2012)

The eleventh plan has the following objectives:

1. Income & Poverty

 o Accelerate GDP growth from 8% to 10% and then maintain at 10% in the 12th
Plan in order to double per capita income by 2016-17
o Increase agricultural GDP growth rate to 4% per year to ensure a broader spread
of benefits
o Create 70 million new work opportunities.
o Reduce educated unemployment to below 5%.
o Raise real wage rate of unskilled workers by 20 percent.
o Reduce the headcount ratio of consumption poverty by 10 percentage points.
2. Education
o Reduce dropout rates of children from elementary school from 52.2% in 2003-04
to 20% by 2011-12
o Develop minimum standards of educational attainment in elementary school, and
by regular testing monitor effectiveness of education to ensure quality
o Increase literacy rate for persons of age 7 years or above to 85%
o Lower gender gap in literacy to 10 percentage points
o Increase the percentage of each cohort going to higher education from the present
10% to 15% by the end of the plan
3. Health
o Reduce infant mortality rate to 28 and maternal mortality ratio to 1 per 1000 live
births
o Reduce Total Fertility Rate to 2.1
o Provide clean drinking water for all by 2009 and ensure that there are no slip-
backs
o Reduce malnutrition among children of age group 0-3 to half its present level
o Reduce anaemia among women and girls by 50% by the end of the plan
4. Women and Children
o Raise the sex ratio for age group 0-6 to 935 by 2011-12 and to 950 by 2016-17
o Ensure that at least 33 percent of the direct and indirect beneficiaries of all
government schemes are women and girl children
o Ensure that all children enjoy a safe childhood, without any compulsion to work
5. Infrastructure
o Ensure electricity connection to all villages and BPL households by 2009 and
round-the-clock power.
o Ensure all-weather road connection to all habitation with population 1000 and
above (500 in hilly and tribal areas) by 2009, and ensure coverage of all
significant habitation by 2015
o Connect every village by telephone by November 2007 and provide broadband
connectivity to all villages by 2012
o Provide homestead sites to all by 2012 and step up the pace of house construction
for rural poor to cover all the poor by 2016-17
6. Environment
o Increase forest and tree cover by 5 percentage points.
o Attain WHO standards of air quality in all major cities by 2011-12.
o Treat all urban waste water by 2011-12 to clean river waters.
o Increase energy efficiency by 20 percentage points by 2016-17.
 NO. OF PERSONS EMPLOYED IN NON-AGRICULTURAL OCCUPATIONS IN
PUBLIC AND PRIVATE SECTORS

After independence, India opted to have a centrally planned economy to ensure an effective and
equitable allocation of national resources for the purpose of balanced economic development.
After liberalization, the emergence of a market economy with a fast growing private sector,
planning has become indicative, rather than prescriptive in nature. The process of formulation
and direction of the Five-Year Plans is carried out by the Planning Commission, headed by the
Prime Minister of India as its chairperson.

Mixed economy

India is a mixed economy combining features of both capitalist market economies and socialist
command economies. Thus, there is a regulated private sector (the regulations have decreased
since liberalization) and a public sector controlled almost entirely by the government. The public
sector generally covers areas which are deemed too important or not profitable enough to leave
to the instability of capitalistic markets. Thus such services as railways and postal system are
carried out by the government.

Since independence, various phases have seen nationalization of such areas as banking, thus
bringing them into the public sector, on one hand, and privatization of some of the Public Sector
Undertakings during the liberalization period on the other.

Public expenditure

HEADQUARTERS OF INDIA'S CENTRAL BANK,

THE RESERVE BANK OF INDIA, IN MUMBAI.

India's public expenditure is classified as development expenditure, comprising of central plan

expenditure and central assistance and non-development expenditures, comprising of capital
expenditure and revenue expenditure. Central plan expenditure is money spent on development
schemes outlined in the plans of the central government and public sector undertakings, while
central assistance refers to financial assistance and developmental loans given for plans of the
state governments and union territories. Non-development capital expenditure comprises of
capital defence expenditure, loans to public enterprises, states and union territories and foreign
governments, while non-development revenue expenditure comprises revenue defence
expenditure, administrative expenditure, subsidies, debt relief to farmers, postal deficit, pensions,
social and economic services (education, health, agriculture, science and technology), grants to
states and union territories and foreign governments.

India's non-development revenue expenditure has increased nearly five-fold in 2003-04 since
1990-91 and more than ten-fold since 1985-1986. Interest payments are the single largest item of
expenditure and accounted for more than 40% of the total non development expenditure in the
2003-04 budge. Defense expenditure increased four-fold during the same period and has been
increasing due to growing tensions in the region, the expensive dispute with Pakistan over
Jammu and Kashmir and an effort to modernize the military. Administrative expenses are
compounded by a large salary and pension bill, which rises periodically due to revisions in
wages, dearness allowance etc. subsidies on food, fertilizers, education and petroleum and other
merit and non-merit subsidies account are not only continuously rising, especially because of
rising crude oil and food prices, but are also harder to rein in, because of political compulsions.

Public receipts

THE 1000 RUPEE NOTE IS THE HIGHEST DENOMINATION PRINTED.

India has a three-tier tax structure, wherein the constitution empowers the union government to
levy Income tax, tax on capital transactions (wealth tax, inheritance tax, gift tax), sales tax,
service tax, customs and excise duties and the state governments to levy sales tax on intra-state
sale of goods, tax on entertainment and professions, excise duties on manufacture of alcohol,
stamp duties on transfer of property and collect land revenue (levy on land owned). The local
governments are empowered by the state government to levy property tax, Octroi and charge
users for public utilities like water supply, sewage etc. More than half of the revenues of the
union and state governments come from taxes, of which half come from Indirect taxes. More
than a quarter of the union government's tax revenues is shared with the state governments.

The tax reforms, initiated in 1991, have sought to rationalize the tax structure and increase
compliance by taking steps in the following directions:

 Reducing the rates of individual and corporate income taxes, excises, customs and
making it more progressive
 Reducing exemptions and concessions
 Simplification of laws and procedures
 Introduction of Permanent account number to track monetary transactions
 Despite protests from traders, 21 of the 29 states introduced Value added tax (VAT) on
April 1, 2005 to replace the complex and multiple sales tax system

The non-tax revenues of the central government come from fiscal services, interest receipts,
public sector dividends, etc., while the non-tax revenues of the States are grants from the central
government, interest receipts, dividends and income from general, economic and social services.

General budget
 P. CHIDAMBARAM IS THE CURRENT FINANCE MINISTER OF INDIA.

The Finance minister of India presents the annual union budget in the Parliament on the last
working day of February. The budget has to be passed by the House before it can come into
effect on April 1, the start of India's fiscal year. The Union budget is preceded by an economic
survey, which is released on the eve of the budget and outlines the broad direction of the budget
and the economic performance of the country for the outgoing financial year.

India's union budget for 2005-06, had an estimated outlay of Rs.5, 14,344 crores ($118 billion).
Earnings from taxes amount to Rs. 2, 73,466 crore ($63b). India's fiscal deficit amounts to 4.5%
or 1,39,231 crore ($32b).

Currency System

Rupee

THE DEPRECIATING RUPEE VALUES OF THE US$ (BLUE) AND UK£ (RED) HAVE
RISEN OVER THE PAST 25 YEARS.

The Rupee is the only legal tender accepted in the India and is also accepted as legal tender in
neighboring Nepal and Bhutan, the latter's currency value being pegged to the rupee.

The rupee is divided into 100 paisa. The highest currency note printed is the 1000 rupee note,
and the lowest denomination in circulation is the 10 p coin.

For higher numeric figures, India uses its own numbering system of counting in lakhs and crores.
A lakh is equal to a hundred thousand, and a crore equal to ten million. The October 2005
exchange rate of about 43.5 to a US dollar, makes a crore (rupees crore) approximately equal to
US$230,000.

Exchange rates

SINCE LIBERALISATION, INDIA HAS RELAXED CONTROLS

ON FOREIGN EXCHANGE, IMPORTS AND FOREIGN INVESTMENT.
THIS HAS LEAD TO INCREASED DISPOSABLE INCOMES,
ESPECIALLY IN URBAN AREAS AND CHEAPER CONSUMER GOODS. PICTURED
HERE IS A SHOPPING AREA IN BANGALORE.

Under the fixed exchange rate system, the value of the rupee was linked to the British pound
sterling till 1946 and after independence, 30% of India's foreign trade was to be determined in
pound sterling. In 1975, as per the Floating exchange rate system, the value of the rupee was
pegged to a basket of currencies and was tightly controlled by the Reserve Bank of India. In
recent years its value has depreciated with respect to most currencies with the exception of the
US dollar.

Since liberalization, the rupee is fully convertible on trade and current account. The former has
enabled Indian businessmen and workers to convert their earnings abroad into rupee at market
rates, while the latter has removed all restrictions on foreign exchange for current business
transactions as well as travel, education, medical expenses, etc., India has committed to gradually
move towards full convertibility, albeit with some restrictions on capital accounts, in order to
encourage two-way flow of capital and investment.

Determinants
Demographics

PERFORMANCE OF INDIAN STATES IN PROVIDING BASIC SOCIAL SERVICES

LIKE EDUCATION, HEALTHCARE, ETC., IN 2001. DARKER STATES HAVE DONE
BETTER.

India, with a population of 1.027 billion people, is the second most populous country in the
world, accounting for nearly 17% of the world's population. Growth rate of population has
shown signs of decrease, coming down from a compound annual growth rate of 2.15 (1951–
1981) to 1.93 (1991–2001); despite the decrease in the death rates owing to improvements in
healthcare.

The large population puts further pressure on infrastructure, social services like education and
has magnified socio-economic problems like unemployment, illiteracy, etc. A positive factor has
been the large working age population, which forms 58.2% of the total population, which is
expected to substantially increase, because of the decrease in dependency ratio. Increased
literacy, better healthcare and self-sufficiency in food production since independence, have
ensured that a large population has not caused any serious problems.

Geography and natural resources

India's geography ranges from mountain ranges to deserts, plains, hills and plateaus, while its
climate varies from tropical in the south to a more temperate climate in the north. India's total
cultivable area is 1,269,219 km² (56.78% of total land area), which is decreasing due to constant
pressure from an ever growing population and increased urbanization.

DAMS LIKE THESE HAVE MITIGATED INDIA'S POWER NEEDS, BUT INDIA
FACES A POWER DEFICIT.

India has a total water surface area of 314,400 km² and receives an average annual rainfall of
1,100 mm. Irrigation accounts for 92% of the water utilization, and comprised 380 km² in 1974,
and is expected to rise to 1,050 km² by 2025, with the balance accounted for by industrial and
domestic consumers. India's inland water resources comprising rivers, canals, ponds and lakes
and marine resources comprising the east and west coasts of the Indian ocean and other gulfs and
bays provide employment to nearly 6 million people in the fisheries sector. India is the sixth
largest producer of fish in the world and second largest in inland fish production.

India's major mineral resources include Coal (fourth-largest reserves in the world), Iron ore,
Manganese, Mica, Bauxite, Titanium ore, Chromites, Natural gas, Diamonds, Petroleum,
Limestone and Thorium (world's largest along Kerala's shores). India's oil reserves, found in
Bombay High off the coast of Maharashtra, Gujarat, and in eastern Assam meet 25% of the
country's demand.

Physical infrastructure

CHEAP AND ENVIRONMENT FRIENDLY PUBLIC TRANSPORT IS SEEN AS A

NECESSITY FOR INDIA'S CROWDED AND POLLUTED METROS. PICTURED
HERE, IS THE NEW DELHI METRO, OPERATIONAL SINCE 2002 AND SEEN AS A
MODEL FOR OTHER METROS.

Since independence, India has allocated nearly half of the total outlay of the five-year plans for
infrastructural development. Much of the total outlay was spent on large projects in the area of
irrigation, energy, transport, communications and social overheads. Development of
infrastructure was completely in the hands of the public sector and was plagued by corruption,
inefficiencies, urban-bias and an inability to scale investment.

India's low spending on power, construction, transportation, telecommunications and real estate,
at $31 billion or 6% of GDP, compared to China's spending of $260 billion or 20% of its GDP in
2002 has prevented India from sustaining a growth rate of around 8%. This has prompted the
government from opening up infrastructure to the private sector and allowing foreign investment.
Politics

India, a federal republic, has had stable democratic governments since independence. Politics is
dominated by the centre-left Indian National Congress (INC), the right-wing Bharatiya Janta
Party (BJP), the left-wing Communist Party of India (CPI) and CPI (Marxist) and various
regional parties, which are either centre-right or centre-left. Despite the varied political
spectrums they occupy, the necessity of forming coalitions for government formation, the
growing middle class that generally favors liberalization and tightening fiscal deficits, especially
at the state levels, has meant that all political parties adopt a moderate view towards economic
reforms.

Financial institutions

THE BOMBAY STOCK EXCHANGE IS ONE OF THE TWO LARGEST STOCK

MARKETS IN INDIA. ITS INDEX IS USED TO GAUGE THE STRENGTH OF THE
INDIAN ECONOMY.

At the time of Independence, India inherited several institutions like the civil services, central
bank, railways, etc., from her British rulers. Mumbai serves as the nation's commercial capital,
with the Reserve Bank of India (RBI), Bombay Stock Exchange (BSE) and the National Stock
Exchange (NSE) located here. The headquarters of many financial institutions are also located
within the city.

The RBI, the country's central bank was established on 1935-04-01. It serves as the nation's
monetary authority, regulator and supervisor of the financial system, manager of exchange
control and as an issuer of currency. The RBI is governed by a central board, headed by a
governor who is appointed by the Central government of India.

The BSE Sensex or the BSE Sensitive Index is a value-weighted index composed of 30
companies with April 1979 as the base year (100). These companies have the largest and most
actively traded stocks and are representative of various sectors, on the Exchange. They account
for around one-fifth of the market capitalization of the BSE. The Sensex is generally regarded as
the most popular and precise barometer of the Indian stock markets. Incorporated in 1992, the
National Stock Exchange is one of the largest and most advanced stock markets in India. The
NSE is the world's third largest stock exchange in terms of transactions. There are a total of 23
stock exchanges in India, but the BSE and NSE comprise 83% of the volumes. The Securities
and Exchange Board of India (SEBI), established in 1992, regulates the stock markets and other
securities markets of the country.

Sectors
Agriculture
Agriculture and allied sectors like forestry, logging and fishing accounted for 25% of the GDP,
employed 57% of the total workforce in 1999-2000 and despite a steady decline of its share in
the GDP, is still the largest economic sector and plays a significant role in the overall socio-
economic development of India. Yields per unit area of all crops have grown since 1950, due to
the special emphasis placed on agriculture in the five-year plans and steady improvements in
irrigation, technology, application of modern agricultural practices and provision of agricultural
credit and subsidies since the green revolution. However, international comparisons reveal that
the average yield in India is generally 30% to 50% of the highest average yield in the world.

The low productivity in India is a result of the following factors:

 Illiteracy, general socio-economic backwardness, slow progress in implementing land

reforms and inadequate or inefficient finance and marketing services for farm produce.
 The average size of land holdings is very small (less than 20,000 m²) and are subject to
fragmentation, due to land ceiling acts and in some cases, family disputes. Such small
holdings are often over-manned, resulting in disguised unemployment and low
productivity of labour.
 Adoption of modern agricultural practices and use of technology is inadequate, hampered
by ignorance of such practices, high costs and impracticality in the case of small land
holdings.
 Irrigation facilities are inadequate, as revealed by the fact that only 53.6% of the land was
irrigated in 2000-01, which result in farmers still being dependent on rainfall, specifically
the Monsoon season. A good monsoon results in a robust growth for the economy as a
whole, while a poor monsoon leads to a sluggish growth.

COMPOSITION OF INDIA'S TOTAL PRODUCTION (MILLION TONNES)

OF FOODGRAINS AND COMMERCIAL CROPS, IN 2003-04

Industry

Ranking for 2005.

Global
Company
ranking
265 Oil and Natural Gas Corporation
269 State Bank of India Group

279 Indian Oil Corporation

309 Reliance Industries Limited

486 National Thermal Power Corporation
Concerted efforts at industrialization by the government, aiming at self-sufficiency in production
and protection from foreign competition, for nearly four decades since independence, have
encouraged a broad industrial base, both in the public and private sectors. They together account
for 28.4% of the GDP and employ 17% of the total workforce. Economic reforms bought foreign
competition, led to privatisation of certain public sector firms, opened up sectors hitherto
reserved for the public sector and the small scale sector and led to an expansion in the production
of durable consumer goods.

Post-liberalization, the Indian private sector, which was usually run by old family firms and
required political connections to prosper was faced with foreign competition and the threat of
cheap Chinese imports. It has, since handled the change by squeezing costs, revamping
management, focusing on designing new products and relying on low labour costs and
technology.

Services

INDIA HAS SET UP SPECIAL ECONOMIC ZONES AND SOFTWARE PARKS THAT
OFFER TAX BENEFITS AND BETTER INFRASTRUCTURE TO SET UP BUSINESS.
PICTURED HERE IS THE TIDEL PARK IN CHENNAI, ONE OF THE LARGEST
SOFTWARE PARKS IN INDIA.

The service sector, providing employment to 23% of the work force, is the fastest growing
sector, with a growth rate of 7.5% in 1991-2000 up from 4.5% in 1951-80. It has the largest
share in the GDP, accounting for 48% in 2000 up from 15% in 1950. Business services
(including information technology (IT) and IT enabled services), communication services,
financial services, hotels and restaurants, community services and trade (distribution) services
are among the fastest growing sectors contributing to one third of the total output of services in
2000. The growth in the service sector is attributed to increased specialization, availability of a
large population of highly-educated and fluent English-speaking workers on the supply side and
on the demand side, increased demand from domestic consumers resulting from growth in
personal incomes and from foreign consumers interested in India's service exports or those
looking to outsource their operations. India's IT industry, despite contributing significantly to its
balance of payments, accounted for only about 1% of the total GDP or 1/50th of the total
services.

Banking and finance

 STRUCTURE OF THE ORGANISED BANKING SECTOR IN INDIA. NUMBER OF
BANKS ARE IN BRACKETS.

The Indian money market is classified into: the organized sector (comprising private, public and
foreign owned commercial banks and cooperative banks, together known as scheduled banks);
and the unorganized sector (comprising individual or family owned indigenous bankers or
money lenders and non-banking financial companies (NBFCs)). The unorganized sector and
microcredit are still preferred over traditional banks in rural and sub-urban areas, especially for
non-productive purposes, like ceremonies and short duration loans.

Indira Gandhi nationalized 14 banks in 1969, followed by seven others in 1980 and made it
mandatory for banks to provide 40% (since reduced to 10%) of their net credit to priority sectors
like agriculture, small-scale industry, retail trade, small businesses, etc. to ensure that the banks
fulfill their social and developmental goals. Since then, the number of bank branches has
increased from 10,120 in 1969 to 98,910 in 2003 and the population covered by a branch
decreased from 63,800 to 15,000 during the same period. The total deposits increased 32.6 times
between 1971 to 1991 compared to 7 times between 1951 to 1971. Despite an increase of rural
branches, from 1,860 or 22% of the total number of branches in 1969 to 32,270 or 48%, only
32,270 out of 5 lakh (500,000) villages are covered by a scheduled bank.

Since liberalization, the government has approved significant banking reforms. While some of
these relate to nationalized banks (like encouraging mergers, reducing government interference
and increasing profitability and competitiveness), other reforms have opened up the banking and
insurance sectors to private and foreign players.

Corruption

EXTENT OF CORRUPTION IN INDIAN STATES, AS MEASURED IN A 2005 STUDY

BY TRANSPARENCY INTERNATIONAL INDIA. (DARKER REGIONS ARE MORE
CORRUPT)

Corruption has been one of the pervasive problems affecting India, along with many developing
countries, which has taken the form of bribes, evasion of tax and exchange controls,
embezzlement, etc. The economic reforms of 1991 reduced the red tape, bureaucracy and the
License Raj that had strangled private enterprise and was blamed for the corruption and
inefficiencies. Yet, a 2005 study by Transparency International (TI) India found that more than
half of those surveyed had firsthand experience of paying bribe or peddling influence to get a job
done in a public office.

The chief economic consequences of corruption are the loss to the exchequer, an unhealthy
climate for investment and an increase in the cost of government-subsidized services. The TI
India study estimates the monetary value of petty corruption in 11 basic services provided by the
government, like education, healthcare, judiciary, police, etc., to be around Rs.21, 068 crores.
India still ranks in the bottom quartile of developing nations in terms of the ease of doing
business, and compared to China, the average time taken to secure the clearances for a startup or
to invoke bankruptcy is much greater.

The Right to Information Act (2005) and equivalent acts in the states that require government
officials to furnish information requested by citizens or face punitive action, computerization of
services and various central and state government acts that established vigilance commissions
have considerably reduced corruption or at least have opened up avenues to redress grievances.

Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an
economy over a period of time. When the price level rises, each unit of currency buys fewer
goods and services; consequently, inflation is also erosion in the purchasing power of money – a
loss of real value in the internal medium of exchange and unit of account in the economy. A
chief measure of price inflation is the inflation rate, the annualized percentage change in a
general price index (normally the Consumer Price Index) over time.

Inflation can have positive and negative effects on an economy. Negative effects of inflation
include loss in stability in the real value of money and other monetary items over time;
uncertainty about future inflation may discourage investment and saving, and high inflation may
lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in
the future. Positive effects include a mitigation of economic recessions, and debt relief by
reducing the real level of debt.

Economists generally agree that high rates of inflation and hyperinflation are caused by an
excessive growth of the money supply. Views on which factors determine low to moderate rates
of inflation are more varied. Low 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. However, 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 mainstream economists favor a low steady rate of inflation. Low (as opposed to
zero or negative) inflation may reduce the severity of economic recessions by enabling the labor
market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents
monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and
stable is usually given to monetary authorities. Generally, these monetary authorities are the
central banks that control the size of the money supply through the setting of interest rates,
through open market operations, and through the setting of banking reserve requirements.
History
Inflation originally referred to the debasement of the currency. When gold was used as currency,
gold coins could be collected by the government, melted down, mixed with other metals such as
silver, copper or lead, and reissued at the same nominal value. By diluting the gold with other
metals, the government could increase the total number of coins issued without also needing to
increase the amount of gold used to make them. When the cost of each coin is lowered in this
way, the government profits from an increase in seignior age. This practice would increase the
money supply but at the same time lower the relative value of each coin. As the relative value of
the coins decrease, consumers would need more coins to exchange for the same goods and
services. These goods and services would experience a price increase as the value of each coin is
reduced.

By the nineteenth century, economists categorized three separate factors that cause a rise or fall
in the price of goods: a change in the value or resource costs of the good, a change in the price of
money which then was usually a fluctuation in metallic content in the currency, and currency
depreciation resulting from an increased supply of currency relative to the quantity of
redeemable metal backing the currency. Following the proliferation of private bank note
currency printed during the American Civil War, the term "inflation" started to appear as a direct
reference to the currency depreciation that occurred as the quantity of redeemable bank notes
outstripped the quantity of metal available for their redemption. The term inflation then referred
to the devaluation of the currency, and not to a rise in the price of goods.

This relationship between the over-supply of bank notes and a resulting depreciation in their
value was noted by earlier classical economists such as David Hume and David Ricardo, who
would go on to examine and debate to what effect a currency devaluation (later termed monetary
inflation) has on the price of goods (later termed price inflation, and eventually just inflation).

Related definitions
The term "inflation" usually refers to a measured rise in a broad price index that represents the
overall level of prices in goods and services in the economy. The Consumer Price Index (CPI),
the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some
examples of broad price indices. The term inflation may also be used to describe the rising level
of prices in a narrow set of assets, goods or services within the economy, such as
commodities(which include food, fuel, metals), financial assets (such as stocks, bonds and real
estate), and services (such as entertainment and health care). The Reuters-CRB Index (CCI), the
Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices
used to measure price inflation in particular sectors of the economy. Asset price inflation is a rise
in the price of assets, as opposed to goods and services. Core inflation is a measure of price
fluctuations in a sub-set of the broad price index which excludes food and energy prices. The
Federal Reserve Board uses the core inflation rate to measure overall inflation, eliminating food
and energy prices to mitigate against short term price fluctuations that could distort estimates of
future long term inflation trends in the general economy.
Other related economic concepts include: deflation – a fall in the general price level; disinflation
– a decrease in the rate of inflation; hyperinflation – an out-of-control inflationary spiral;
stagflation – a combination of inflation, slow economic growth and high unemployment; and
inflation – an attempt to raise the general level of prices to counteract deflationary pressures.

Measures
Inflation is usually estimated by calculating the inflation rate of a price index, usually the
Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and
services purchased by a "typical consumer".[18] The inflation rate is the percentage rate of change
of a price index over time.

For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008
it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over
the course of 2007 is

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general
level of prices for typical U.S. consumers rose by approximately four percent in 2007. [19]

Other widely used price indices for calculating price inflation include the following:

 Cost-of-living indices (COLI) are indices similar to the CPI which are often used to
adjust fixed incomes and contractual incomes to maintain the real value of those incomes.
 Producer price indices (PPIs) which measures average changes in prices received by
domestic producers for their output. This differs from the CPI in that price subsidization,
profits, and taxes may cause the amount received by the producer to differ from what the
consumer paid. There is also typically a delay between an increase in the PPI and any
eventual increase in the CPI. Producer price index 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
United States, an earlier version of the PPI was called the Wholesale Price Index.
 Commodity 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 quickly due to changes in
supply and demand conditions in the food and oil markets, 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 index like the CPI. Because core
inflation is less affected by short run supply and demand conditions in specific markets,
central banks rely on it to better measure the inflationary impact of current monetary
policy.
Other common measures of inflation are:

 GDP deflator is a measure of the price of all the goods and services included in Gross
Domestic Product (GDP). The US Commerce Department publishes a deflator series for
US GDP, defined as its nominal GDP measure divided by its real GDP measure.
 Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down
to different regions of the US.
 Historical inflation Before 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. Most inflation data
before the early 20th century is imputed based on the known costs of goods, rather than
compiled at the time. It is also used to adjust 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
stock (equity) and real estate. While there is no widely-accepted index of this type, some
central bankers have suggested that it would be better to aim at stabilizing a wider
general price level inflation measure that includes some asset prices, instead of stabilizing
CPI or core inflation only. The reason is that by raising interest rates when stock prices or
real estate prices rise, and lowering them when these asset prices fall, central banks might
be more successful in avoiding bubbles and crashes in asset prices.

Issues in measuring

Measuring inflation in an economy requires objective means of differentiating changes in

nominal prices on a common set of goods and services, and distinguishing them from those price
shifts resulting from changes in value such as volume, quality, or performance. For example, if
the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no
change in quality, then this price difference represents inflation. This single price change would
not, however, represent general inflation in an overall economy. To measure overall inflation, the
price change of a large "basket" of representative goods and services is measured. This is the
purpose of a price index, which is the combined price of a "basket" of many goods and services.
The combined price is the sum of the weighted average prices of items in the "basket". A
weighted price is calculated by multiplying the unit price of an item to the number of those items
the average consumer purchases. Weighted pricing is a necessary means to measuring the impact
of individual unit price changes on the economy's overall inflation. The Consumer Price Index,
for example, uses data collected by surveying households to determine what proportion of the
typical consumer's overall spending is spent on specific goods and services, and weights the
average prices of those items accordingly. Those weighted average prices are combined to
calculate the overall price. To better relate price changes over time, indexes typically choose a
"base year" price and assign it a value of 100. Index prices in subsequent years are then
expressed in relation to the base year price.

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

Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost
shifts. For example, home heating costs are expected to rise in colder months, and seasonal
adjustments are often used when measuring for inflation to compensate for cyclical spikes in
energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical
techniques in order to remove statistical noise and volatility of individual prices.

When looking at inflation economic institutions may focus only on certain kinds of prices, or
special indices, such as the core inflation index which is used by central banks to formulate
monetary policy.

Effects
General

An increase in the general level of prices implies a decrease in the purchasing power of the
currency. That is, when the general level of prices rises, each monetary unit buys fewer goods
and services. The effect of inflation is not distributed evenly, and as a consequence there are
hidden costs to some and benefits to others from this decrease in purchasing power. For example,
with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will
lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or
institutions with cash assets will experience a decline in the purchasing power of their holdings.
Increases in payments to workers and pensioners often lag behind inflation, especially for those
with fixed payments.

An increase in the price level (inflation) erodes the real value of money (the functional currency)
and other items with an underlying monetary nature (e.g. loans and bonds). However, inflation
has no effect on the real value of non-monetary items, (e.g. goods and commodities, gold, real
estate).

Negative

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add
inefficiencies in the market, and make it difficult for companies to budget or plan long-term.
Inflation can act as a drag on productivity as companies are forced to shift resources away from
products and services in order to focus on profit and losses from currency inflation. Uncertainty
about the future purchasing power of money discourages investment and saving. And inflation
can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax
rates.

With high inflation, purchasing power is redistributed from those on fixed incomes such as
pensioners towards those with variable incomes whose earnings may better keep pace with the
inflation. This redistribution of purchasing power will also occur between international trading
partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its
exports to become more expensive and affect the balance of trade. There can also be negative
impacts to trade from an increased instability in currency exchange prices caused by
unpredictable inflation.

Cost-push inflation
Rising inflation can prompt employees to demand higher wages, to keep up with
consumer prices. Rising wages in turn can help fuel inflation. In the case of collective
bargaining, wages will be set as a factor of price expectations, which will be higher when
inflation has an upward trend. This can cause a wage spiral. In a sense, inflation begets
further inflationary expectations.
Hoarding
People buy consumer durables as stores of wealth in the absence of viable alternatives as
a means of getting rid of excess cash before it is devalued, creating shortages of the
hoarded objects.
Hyperinflation
If inflation gets totally out of control (in the upward direction), it can grossly interfere
with the normal workings of the economy, hurting its ability to supply.
Allocate efficiency
A change in the supply or demand for a good will normally cause its price to change,
signaling to buyers and sellers that they should re-allocate resources in response to the
new market conditions. But when prices are constantly changing due to inflation, genuine
price signals get lost in the noise, so agents are slow to respond to them. The result is a
loss of locative efficiency.
Shoe leather cost
High inflation increases the opportunity cost of holding cash balances and can induce
people to hold a greater portion of their assets in interest paying accounts. However, since
cash is still needed in order to carry out transactions this means that more "trips to the
bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe
leather" with each trip.
Menu costs
With high inflation, firms must change their prices often in order to keep up with
economy wide changes. But often changing prices is itself a costly activity whether
explicitly, as with the need to print new menus, or implicitly.
Business cycles
According to the Austrian Business Cycle Theory, inflation sets off the business cycle.
Austrian economists hold this to be the most damaging effect of inflation. According to
Austrian theory, artificially low interest rates and the associated increase in the money
supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments,
which eventually have to be liquidated as they become unsustainable.

Positive

Labor-market adjustments
 Keynesians believe that nominal wages are slow to adjust downwards. This can lead to
prolonged disequilibrium and high unemployment in the labor market. Since inflation
would lower the real wage if nominal wages are kept constant, Keynesians argue that
some inflation is good for the economy, as it would allow labor markets to reach
equilibrium faster.
Debt relief
Debtors who have debts with a fixed nominal rate of interest will see a reduction in the
"real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal
rate minus the inflation rate. (R=n-i) For example if you take a loan where the stated
interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying
for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of
6% and the inflation rate jumped to 20% you would have a real interest rate of -14%.
Banks and other lenders adjust for this inflation risk either by including an inflation
premium in the costs of lending the money by creating a higher initial stated interest rate
or by setting the interest at a variable rate.
Room to maneuver
The primary tools for controlling the money supply are the ability to set the discount rate,
the rate at which banks can borrow from the central bank, and open market operations
which are the central bank's interventions into the bonds market with the aim of affecting
the nominal interest rate. If an economy finds itself in a recession with already low, or
even zero, nominal interest rates, then the bank cannot cut these rates further (since
negative nominal interest rates are impossible) in order to stimulate the economy - this
situation is known as a liquidity trap. A moderate level of inflation tends to ensure that
nominal interest rates stay sufficiently above zero so that if the need arises the bank can
cut the nominal interest rate.
Tobin effect
The Nobel Prize winning economist James Tobin at one point had argued that a moderate
level of inflation can increase investment in an economy leading to faster growth or at
least higher steady state level of income. This is due to the fact that inflation lowers the
return on monetary assets relative to real assets, such as physical capital. To avoid
inflation, investors would switch from holding their assets as money (or a similar,
susceptible to inflation, form) to investing in real capital projects. See Tobin monetary
model

Causes
Historically, a great deal of economic literature was concerned with the question of what causes
inflation and what effect it has. There were different schools of thought as to the causes of
inflation. Most can be divided into two broad areas: quality theories of inflation and quantity
theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting
currency to be able to exchange that currency at a later time for goods that are desirable as a
buyer. The quantity theory of inflation rests on the quantity equation of money that relates the
money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume
proposed a quantity theory of inflation for money, and a quality theory of inflation for
production.
Currently, the quantity theory of money is widely accepted as an accurate model of inflation in
the long run. Consequently, there is now broad agreement among economists that in the long run,
the inflation rate is essentially dependent on the growth rate of money supply. However, in the
short and medium term inflation may be affected by supply and demand pressures in the
economy, and influenced by the relative elasticity of wages, prices and interest rates. The
question of whether the short-term effects last long enough to be important is the central topic of
debate between monetarist and Keynesian economists. In monetarism prices and wages adjust
quickly enough to make other factors merely marginal behavior on a general trend-line. In the
Keynesian view, prices and wages adjust at different rates, and these differences have enough
effects on real output to be "long term" in the view of people in an economy.

Keynesian view

Keynesian economic theory proposes that changes in money supply do not directly affect prices,
and that visible inflation is the result of pressures in the economy expressing themselves in
prices. The supply of money is a major, but not the only, cause of inflation.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle
model":

 Demand-pull inflation is caused by increases in aggregate demand due to increased

private and government spending, etc. Demand inflation is constructive to a faster rate of
economic growth since the excess demand and favorable market conditions will stimulate
investment and expansion.
 Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate
supply (potential output). This may be due to natural disasters, or increased prices of
inputs. For example, a sudden decrease in the supply of oil, leading to increased oil
prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could
then pass this on to consumers in the form of increased prices.
 Built-in inflation is induced by adaptive expectations, and is often linked to the
"price/wage spiral". It involves workers trying to keep their wages up with prices (above
the rate of inflation), and firms passing these higher labor costs on to their customers as
higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and
so might be seen as hangover inflation.

Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is
increased beyond the ability of the economy to produce (its potential output). Hence, any factor
that increases aggregate demand can cause inflation. However, in the long run, aggregate
demand can be held above productive capacity only by increasing the quantity of money in
circulation faster than the real growth rate of the economy. Another (although much less
common) cause can be a rapid decline in the demand for money, as happened in Europe during
the Black Death, or in the Japanese occupied territories just before the defeat of Japan in 1945.

The effect of money on inflation is most obvious when governments finance spending in a crisis,
such as a civil war, by printing money excessively. This sometimes leads to hyperinflation, a
condition where prices can double in a month or less. Money supply is also thought to play a
major role in determining moderate levels of inflation, although there are differences of opinion
on how important it is. For example, Monetarist economists believe that the link is very strong;
Keynesian economists, by contrast, typically emphasize the role of aggregate demand in the
economy rather than the money supply in determining inflation. That is, for Keynesians, the
money supply is only one determinant of aggregate demand.

Some Keynesian economists also disagree with the notion that central banks fully control the
money supply, arguing that central banks have little control, since the money supply adapts to
the demand for bank credit issued by commercial banks. This is known as the theory of
endogenous money, and has been advocated strongly by post-Keynesians as far back as the
1960s. It has today become a central focus of Taylor rule advocates. This position is not
universally accepted – banks create money by making loans, but the aggregate volume of these
loans diminishes as real interest rates increase. Thus, central banks can influence the money
supply by making money cheaper or more expensive, thus increasing or decreasing its
production.

A fundamental concept in inflation analysis is the relationship between inflation and

unemployment, called the Phillips curve. This model suggests that there is a trade-off between
price stability and employment. Therefore, some level of inflation could be considered desirable
in order to minimize unemployment. The Phillips curve model described the U.S. experience
well in the 1960s but failed to describe the combination of rising inflation and economic
stagnation (sometimes referred to as stagflation) experienced in the 1970s.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-
off between inflation and unemployment changes) because of such matters as supply shocks and
inflation becoming built into the normal workings of the economy. The former refers to such
events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and
inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the
Phillips curve represents only the demand-pull component of the triangle model.

Another concept of note is the potential output (sometimes called the "natural gross domestic
product"), a level of GDP, where the economy is at its optimal level of production given
institutional and natural constraints. (This level of output corresponds to the Non-Accelerating
Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-
employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the
NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-
in inflation worsens. If GDP falls below its potential level (and unemployment is above the
NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and
undermining built-in inflation.

However, one problem with this theory for policy-making purposes is that the exact level of
potential output (and of the NAIRU) is generally unknown and tends to change over time.
Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can
change because of policy: for example, high unemployment under British Prime Minister
Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many
of the unemployed found themselves as structurally unemployed (also see unemployment),
unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller
percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing
the threshold into the realm of accelerating inflation.

Monetarist view

For more details on this topic, see Monetarists.

Monetarists believe the most significant factor influencing inflation or deflation is the
management of money supply through the easing or tightening of credit. They consider fiscal
policy, or government spending and taxation, as ineffective in controlling inflation.[28] According
to the famous monetarist economist Milton Friedman, "Inflation is always and everywhere a
monetary phenomenon."

Monetarists assert that the empirical study of monetary history shows that inflation has always
been a monetary phenomenon. The quantity theory of money, simply stated, says that the total
amount of spending in an economy is primarily determined by the total amount of money in
existence. This theory begins with the identity:

Where

M is the quantity of money.

V is the velocity of money in final expenditures;
P is the general price level;
Q is an index of the real value of final expenditures;

In this formula, the general price level is affected by the level of economic activity (Q), the
quantity of money (M) and the velocity of money (V). The formula is an identity because the
velocity of money (V) is defined to be the ratio of final expenditure ( ) to the quantity of
money (M).

Velocity of money is often assumed to be constant, and the real value of output is determined in
the long run by the productive capacity of the economy. Under these assumptions, the primary
driver of the change in the general price level is changes in the quantity of money. With constant
velocity, the money supply determines the value of nominal output (which equals final
expenditure) in the short run. In practice, velocity is not constant, and can only be measured
indirectly and so the formula does not necessarily imply a stable relationship between money
supply and nominal output. However, in the long run, changes in money supply and level of
economic activity usually dwarf changes in velocity. If velocity is relatively constant, the long
run rate of increase in prices (inflation) is equal to the difference between the long run growth
rate of money supply and the long run growth rate of real output.
Rational expectations theory

Main article: Rational expectations theory

Rational expectations theory holds that economic actors look rationally into the future when
trying to maximize their well-being, and do not respond solely to immediate opportunity costs
and pressures. In this view, while generally grounded in monetarism, future expectations and
strategies are important for inflation as well.

A core assertion of rational expectations theory is that actors will seek to "head off" central-bank
decisions by acting in ways that fulfill predictions of higher inflation. This means that central
banks must establish their credibility in fighting inflation, or have economic actors make bets
that the economy will expand, believing that the central bank will expand the money supply
rather than allow a recession.

Austrian theory

For more details on this topic, see The Austrian view of inflation

The Austrian School asserts that inflation is an increase in the money supply, rising prices are
merely consequences and this semantic difference is important in defining inflation. Austrian
economists believe there is no material difference between the concepts of monetary inflation
and general price inflation. Austrian economists measure monetary inflation by calculating the
growth of new units of money that are available for immediate use in exchange, that have been
created over time. This interpretation of inflation implies that inflation is always a distinct action
taken by the central government or its central bank, which permits or allows an increase in the
money supply. In addition to state-induced monetary expansion, the Austrian School also
maintains that the effects of increasing the money supply are magnified by credit expansion, as a
result of the fractional-reserve banking system employed in most economic and financial systems
in the world.

Austrians argue that the state uses inflation as one of the three means by which it can fund its
activities (inflation tax), the other two being taxation and borrowing. Various forms of military
spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short
term way of acquiring marketable resources and is often favored by desperate, indebted
governments.

In other cases, Austrians argue that the government actually creates economic recessions and
depressions, by creating artificial booms that distort the structure of production. The central bank
may try to avoid or defer the widespread bankruptcies and insolvencies which cause economic
recessions or depressions by artificially trying to "stimulate" the economy through "encouraging"
money supply growth and further borrowing via artificially low interest rates. Accordingly, many
Austrian economists support the abolition of the central banks and the fractional-reserve banking
system, and advocate returning to a 100 percent gold standard, or less frequently, free banking.
They argue this would constrain unsustainable and volatile fractional-reserve banking practices,
ensuring that money supply growth (and inflation) would never spiral out of control.
Real bills doctrine

Main article: Real bills doctrine

Within the context of a fixed specie basis for money, one important controversy was between the
quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory
applies to the level of fractional reserve accounting allowed against specie, generally gold, held
by a bank. Currency and banking schools of economics argue the RBD that banks should also be
able to issue currency against bills of trading, which is “real bills that they buy from merchants.
This theory was important in the 19th century in debates between "Banking" and "Currency"
schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the
collapse of the international gold standard post 1913, and the move towards deficit financing of
government, RBD has remained a minor topic, primarily of interest in limited contexts, such as
currency boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the
Federal Reserve going so far as to say it had been "completely discredited." Even so, it has
theoretical support from a few economists, particularly those that see restrictions on a particular
class of credit as incompatible with libertarian principles of laissez-faire, even though almost all
libertarian economists are opposed to the RBD.

The debate between currency, or quantity theory, and banking schools in Britain during the 19th
century prefigures current questions about the credibility of money in the present. In the 19th
century the banking school had greater influence in policy in the United States and Great Britain,
while the currency school had more influence "on the continent", that is in non-British countries,
particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

Anti-classical or backing theory

Another issue associated with classical political economy is the anti-classical hypothesis of
money, or "backing theory". The backing theory argues that the value of money is determined by
the assets and liabilities of the issuing agency. Unlike the Quantity Theory of classical political
economy, the backing theory argues that issuing authorities can issue money without causing
inflation so long as the money issuer has sufficient assets to cover redemptions.

Controlling inflation
A variety of methods have been used in attempts to control inflation.

Monetary policy

Main article: Monetary policy

The U.S. effective federal funds rate charted over fifty years.
Today the primary tool for controlling inflation is monetary policy. Most central banks are
tasked with keeping the federal funds lending rate at a low level; normally to a target rate around
2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to
6% per annum. A low positive inflation is usually targeted, as deflationary conditions are seen as
dangerous for the health of the economy.

There are a number of methods that have been suggested to control inflation. Central banks such
as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest
rates and through other operations. High interest rates and slow growth of the money supply are
the traditional ways through which central banks fight or prevent inflation, though they have
different approaches. For instance, some follow a symmetrical inflation target while others only
control inflation when it rises above a target, whether express or implied.

Monetarists emphasize keeping the growth rate of money steady, and using monetary policy to
control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians
emphasize reducing aggregate demand during economic expansions and increasing demand
during recessions to keep inflation stable. Control of aggregate demand can be achieved using
both monetary policy and fiscal policy (increased taxation or reduced government spending to
reduce demand).

Fixed exchange rates

Main article: Fixed exchange rate

Under a fixed exchange rate currency regime, a country's currency is tied in value to another
single currency or to a basket of other currencies (or sometimes to another measure of value,
such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis
the currency it is pegged to. It can also be used as a means to control inflation. However, as the
value of the reference currency rises and falls, so does the currency pegged to it. This essentially
means that the inflation rate in the fixed exchange rate country is determined by the inflation rate
of the country the currency is pegged to. In addition, a fixed exchange rate prevents a
government from using domestic monetary policy in order to achieve macroeconomic stability.

Under the Bretton Woods agreement, most countries around the world had currencies that were
fixed to the US dollar. This limited inflation in those countries, but also exposed them to the
danger of speculative attacks. After the Bretton Woods agreement broke down in the early
1970s, countries gradually turned to floating exchange rates. However, in the later part of the
20th century, some countries reverted to a fixed exchange rate as part of an attempt to control
inflation. This policy of using a fixed exchange rate to control inflation was used in many
countries in South America in the later part of the 20th century (e.g. Argentina (1991-2002),
Bolivia, Brazil, and Chile).
Gold standard

Under a gold standard, paper notes are convertible into pre-set, fixed quantities of gold.

The gold standard is a monetary system in which a region's common media of exchange are
paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The
standard specifies how the gold backing 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 equivalent specie. A U.S. silver certificate, for example, could be
redeemed for an actual piece of silver.

Gold was a common form of representative money due to its rarity, durability, divisibility,
fungibility, and ease of identification. Representative money and the gold standard were used to
protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some
countries during the Great Depression. However, they were not without their problems and
critics, and so were partially abandoned via the international adoption of the Breton Woods
System. Under this system all other major currencies were tied at fixed rates to the dollar, which
itself was tied to gold at the rate of $35 per ounce. The Breton Woods system broke down in
1971, causing most countries to switch to fiat money – money backed only by the laws of the
country. Austrian economists strongly favor a return to a 100 percent gold standard.

Under a gold standard, the long term rate of inflation (or deflation) would be determined by the
growth rate of the supply of gold relative to total output. Critics argue that this will cause
arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be
determined by gold mining, which some believe contributed to the Great Depression.

Wage and price controls

Main article: Incomes policies

Another method attempted in the past has been wage and price controls ("incomes policies").
Wage and price controls have been successful in wartime environments in combination with
rationing. However, their use in other contexts is far more mixed. Notable failures of their use
include the 1972 imposition of wage and price controls by Richard Nixon. More successful
examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in
the Netherlands.

In general wage and price controls are regarded as a temporary and exceptional measure, only
effective when coupled with policies designed to reduce the underlying causes of inflation during
the wage and price control regime, for example, winning the war being fought. They often have
perverse effects, due to the distorted signals they send to the market. Artificially 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. For example, if the official price of bread is too low, there will be too little bread at
official prices, and too little investment in bread making by the market to satisfy future needs,
thereby exacerbating the problem in the long term.

Temporary controls may complement a recession as a way to fight inflation: the controls make
the recession more efficient as a way to fight inflation (reducing the need to increase
unemployment), while the recession prevents the kinds of distortions that controls cause when
demand is high. However, in general the advice of economists is not to impose price controls but
to liberalize prices by assuming that the economy will adjust 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 (see creative destruction).

Cost-of-living allowance

For more details on this topic, see Cost of living.

The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-
adjusted to keep their real values constant. In many countries, employment contracts, pension
benefits, and government entitlements (such as social security) are tied to a cost-of-living index,
typically to the consumer price index. A cost-of-living allowance (COLA) adjusts salaries based
on changes in a cost-of-living index. Salaries are typically adjusted annually. They may also be
tied to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future percentage
increases in worker pay which are not tied to any index. These negotiated increases in pay are
colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their
similarity to increases tied to externally-determined indexes. Many economists and
compensation analysts consider the idea of predetermined future "cost of living increases" to be
misleading for two reasons: (1) For most recent periods in the industrialized world, average
wages have increased faster than most calculated cost-of-living indexes, reflecting the influence
of rising productivity and worker bargaining power rather than simply living costs, and (2) most
cost-of-living indexes are not forward-looking, but instead compare current or historical data.