Keywords: financial market, functions of financial market, financial market classification, money market, money and market, financial market, money and financial market, money and banking, stock market, financial transaction, call money market, treasury bill market, commercial bill market, collateral loan market, commercial paper market, securities, corporate securities, ownership securities, creditorship securities, preference shares, equity shares, debenture.
Financial Awareness for Competitive Exams—UPSC/IAS/PCS/Banking/ SSC/ Railway/etc.
“If a person is not making mistakes, then he’s not doing anything. It is better to make mistake by doing something than to be mistake-free by doing nothing.” __ Dr. Md. Usmangani Ansari
A place or platform where individuals are involved in any kind of financial transaction is known as financial market. Financial market is a platform where buyers and sellers are involved in sale and purchase of financial products like shares, mutual funds, bonds and so on. Often, they are called by different names, including “Wall Street” and “capital market,” but all of them still mean one and the same thing. Simply put, businesses and investors can go to financial markets to raise money to grow their business and to make more money, respectively.
To make it more clearly, let us take an example of a bank where an individual maintains a savings account. The bank can use their money and the money of other depositors to loan to other individuals and organizations and charge an interest fee.
The depositors themselves also earn and see their money grow through the interest that is paid to it. Therefore, the bank serves as a financial market that benefits both the depositors and the debtors.
Financial Market’s Functions
The important functions of the financial market are given below:
- Financial market mobilizes savings by trading it in the most productive methods.
- It assists in deciding the securities price by interaction with the investors and depending on the demand and supply in the market.
- It gives liquidity to bartered assets.
- Less time-consuming and cost-effective as parties don’t have to spend extra time and money to find potential clients to deal with securities. It also decreases cost by giving valuable information about the securities traded in the financial market.
Financial Market Classification
The financial market can be classified on the following basis:
- Based on Nature of Claim
- Debt Market: It is a market where fixed bonds and debentures or bonds are exchanged between investors.
- Equity Market: It is a place for investors to deal with equity.
- Based on Maturity of Claim
- Money Market:It deals with monetary assets and short-term funds such as a certificate of deposits, treasury bills, and commercial paper, etc. which mature within twelve months.
- Capital Market:It trades medium and long term financial assets.
- Based on Timing of Delivery
- Cash Market:It is a market place where trade is completed in real-time.
- Futures Market: Here, the delivery or compensation of products are taken in the future specified date.
- Based on Organizational Structure
- Exchange-Traded Market: It has a centralised system with a patterned procedure.
- Over-the-Counter Market:It has a decentralised organisation with customised procedures.
A. WHAT IS MONEY MARKET?
Money market basically refers to a section of the financial market where financial instruments with high liquidity and short-term maturities are traded. Money market has become a component of the financial market for buying and selling of securities of short-term maturities, of one year or less, such as treasury bills and commercial papers.
Over-the-counter trading is done in the money market and it is a wholesale process. It is used by the participants as a way of borrowing and lending for the short term.
Money market consists of negotiable instruments such as treasury bills, commercial papers, and certificates of deposit. It is used by many participants, including companies, to raise funds by selling commercial papers in the market. Money market is considered a safe place to invest due to the high liquidity of securities.
It has certain risks which investors should be aware of, one of them being default on securities such as commercial papers. Money market consists of various financial institutions and dealers, who seek to borrow or loan securities. It is the best source to invest in liquid assets.
The money market is an unregulated and informal market and not structured like the capital markets, where things are organised in a formal way. Money market gives lesser return to investors who invest in it but provides a variety of products.
Withdrawing money from the money market is easier.
Money Market’s Functions
The money market is the platform that contributes to the economic stability and development of a country by providing short-term liquidity to governments, commercial banks, and other large organizations. Investors with excess money that they do not need can invest it in the money market and earn interest.
The main functions of the money market are the followings:
- Financing Trade
The money market works as institution to provide financing to local and international traders who are in urgent need of short-term funds. It provides a facility to discount bills of exchange, and this provides immediate financing to pay for goods and services. International traders benefit from the acceptance houses and discount markets. The money market also makes funds available for other units of the economy such as agriculture and small-scale industries.
- Central Bank Policies
The central bank of a country such as Reserve Bank of India (RBI) in our country is responsible for guiding the monetary policy of a country and taking measures to ensure a healthy financial system. Through the money market, the central bank can perform its policy-making function efficiently. For example, the short-term interest rates in the money market represent the prevailing conditions in the banking industry and can guide the central bank in developing an appropriate interest rate policy. Also, the integrated money markets help the central bank to influence the sub-markets and implement its monetary policy objectives.
- Growth of Industries
The institutions of money market provide an easy avenue where businesses can obtain short-term loans to finance their working capital needs. Due to the large volume of transactions, businesses may experience cash shortages related to buying raw materials, paying employees, or meeting other short-term expenses. Through commercial paper and finance bills, they can easily borrow money on a short-term basis. Although the money market does not provide long-term loans, it influences the capital market and can also help businesses obtain long-term financing. The capital market benchmarks its interest rates based on the prevailing interest rate in the money market.
- Commercial Banks Self-Sufficiency
The money market provides commercial banks with a ready market where they can invest their excess reserves and earn interest while maintaining liquidity. The short-term investments such as bills of exchange can easily be converted to cash to support customer withdrawals. Also, when faced with liquidity problems, they can borrow from the money market on a short-term basis as an alternative to borrowing from the central bank. The advantage of this is that the money market may charge lower interest rates on short-term loans than the central bank typically does.
TYPES AND INSTRUMENTS OF MONERY MARKET
1. Call Money Market
- A money market, which involves financial transactions (lending and borrowing) for only a small period, is called a “call money market”, in other words, a “short-term money market”. Call money transactions are limited between a day and a fortnight and are mostly applied in the case of interbank exchanges.
- Call Money, Notice Money, and Term Money markets are vital components of the Indian Money Market.
- Call money involves monetary transactions for a day; notice money refers to the borrowing and lending of funds for 2 – 14 days and term money refers to financial transactions with a time frame exceeding a fortnight.
- For such markets, the interest rates are subjected to market conditions and bizscapes. For instance, in India, the public sector banks account for 80% of the demand whereas the foreign and the private players result for the remaining 20%. To cater to these demands, institutions like IDBI and LIC supply the majority of the short term funds to the state banks as well as other banks.
- Since banks feature as lenders and borrowers in this process, it is called Inter-Bank Market.
- Call money is mostly liquid money and policies are framed with regards to the RBI intervention. These short term policies are located in established cities like Chennai, Kolkata, Mumbai, and Delhi.
2. Treasury Bill Market
- Short – term securities that mature within a year from their issue date are called Treasury Bills (T-Bills). These policies are effectively deployed by the US Government to raise money from the public.
- Initially, T-Bills are purchased at prices lower than their par (Face) value and after maturity, the government pays the bearer, the full par value. Mathematically, the interest is the difference between the purchase price of the security and the amount received post maturity.
- A competitive bidding or auction process is employed to issue T – Bills; either non – competitive wherein the return is specified post the bidding process and competitive wherein the bidder needs to specify the expected return.
- Individuals, Firms, Trusts, Institutions, and banks can purchase T-Bills.
- The advantages of such bills are as follows:
- Zero Risk: T-Bills are issued by the Government and thus, the investor has no botheration
- High Liquidity: Short-term investments (3 months, 6 months, 9 months)
- Transparency: Regulated by the Government.
- High Tradability: The secondary market of T-Bills is highly organized
- The Central Government of India issues such bills, for a minimum amount of Rs. 25, 000 and in multiples of the same.
3. Commercial Bill Market
- The commercial bill market relates to the seller and buyer equation over the purchased goods.
- Commercial bills are issued by the seller (drawer) on the buyer (drawee) for the value of the goods or products delivered by him.
- Commercial bills are considered as marketable investments. The process involves a seller (in need of funds) sending a bill to the buyer, who in turn accepts the same and promises on-time payment. The bank can also be approached to accept the bill. The bank levies a commission for the acceptance of the bill and vows to pay if the buyer defaults. Following this protocol, the seller can sell his goods in the market.
- Such bills are instrumental in providing short-term financial impetus to businesses. However, these bills failed to be effective as the cash credit scheme is the prime form of bank lending and big corporate firms do not abide by the principle of timely payments.
- The difference between the commercial and the T-Bill is that the latter is issued by the Government whereas the former is imposed by the seller.
4. Collateral Loan Market
- Providing and availing loans is a primary factor in the financial market. In those cases where the principal amount of the loan is in massive proportion, the lender (banks mostly) imposes collateral on the borrower.
- Collateral represents the asset that can be pledged, as a security to the creditor by the borrower. The collateral amount depends according to the value of the loan.
- The collateral policies are implemented in case of real estate purchase or car purchase. Here, the property itself or the vehicle will act as collateral, until the loan is paid in full.
- Complete information related to such loans is furnished in a contract, which is signed by the lender and the borrower.
- For loans on vehicles, the vehicle itself is kept as security, In the condition of a default in the borrower’s repayment, the vehicle would be legally seized by the financial institution, which it is hypothecated to.
- Jewelry and other securities can also be used as collateral in giving loans. In such cases, the ownership of these securities remains with the borrower but in case of a failure to repay, the ownership rights are transferred to the bank.
- The collateral process provides a level of confidence and assurance at the time of giving the loan.
5. Commercial Paper Market
- Commercial paper is an unstructured or rather unsecured bond, issued by a corporation, based on receivables and inventories. Maturities on such bonds are no longer than nine months.
- These alternatives are targeted by organizations, aiming at borrowing short – term money from banks. The conventional process, being very tedious and process-oriented, has led to the fame of commercial paper.
- This method is otherwise very safe, as it easily indicates the financial condition of a company within a few months. There have not been many cases of defaulters in the last four decades, because commercial papers are issued to companies with high credit ratings and a good reputation only.
- The commercial paper market provides a means for corporations to borrow money to cover short-term debt obligations, such as payroll.
B. WHAT IS CAPITAL MARKET?
A market where individuals invest for a longer duration i.e. more than a year is called as capital market. In a capital market various financial institutions raise money from individuals and invest it for a longer period.
Capital Market is further divided into:
- Primary Market: Primary Market is a form of capital market where various companies issue new stock, shares and bonds to investors in the form of IPO’s (Initial Public Offering). Primary Market is a form of market where stocks and securities are issued for the first time by organizations.
- Secondary Market: Secondary market is a form of capital market where stocks and securities which have been previously issued are bought and sold.
What are the types of Capital Market?
The Capital Market is of the following types:
- Stock Markets: Stock Market is a type of Capital market which deals with the issuance and trading of shares and stocks at a certain price.
- Bond Markets: Bond Market is a form of capital market where buyers and sellers are involved in the trading of bonds.
- Commodity Market: A market which facilitates the sale and purchase of raw goods is called a commodity market. Commodity market like any other market includes a buyer and a seller. In such a market buyer purchases raw products like rice, wheat, grain, cattle and so on from the seller at a mutually agreed rate.
- Money Market: As the name suggests, money market involves individuals who deal with the lending and borrowing of money for a short time frame.
- Derivatives Market: The market which deals with the trading of contracts which are derived from any other asset is called as derivative market.
- Future Market: Future market is a type of financial market which deals with the trading of financial instruments at a specific rate where in the delivery takes place in future.
- Insurance Market: Insurance market deals with the trading of insurance products. Insurance companies pay a certain amount to the immediate family members of owner of the policy in case of his untimely death.
- Foreign Exchange Market: Foreign exchange market is a globally operating market dealing in the sale and purchase of foreign currencies.
- Private Market: Private market is a form of market where transaction of financial products takes place between two parties directly.
10. Mortgage Market: A type of market where various financial organizations are involved in providing loans to individuals on various residential and commercial properties for a specific duration is called a mortgage market. The payment is made to the individual concerned on submitting certain necessary documents and fulfilling certain basic criteria.
What are the types of Securities?
- Gilt-edged Securities
- There are securities issued by the government to borrow money from the market. These government-issued securities are called gilt or gilt-edged securities.
- Should there arise a situation wherein the Government creates security for raising a public loan, an intimation regarding the same is notified in the Official Gazette under the Government Securities Act, 2016.
- Gilt-edged securities are a high – grade investment with very low risk.
- High – grade bonds can also be issued by private firms too, which flaunts a long record of consistent earnings and possess the ability to pay its obligations on time and not accrue any bad debts in business transactions.
- The term, ‘gilt-edge’ initially originated from Britain; then referred to the debt securities issued by the Bank of England, on behalf of His/ Her Majesty’s Treasure.
- Depending upon expiry date, government securities are classified into the following:
Short–term gilt: Maturity: >1 year Long–term gilt: Maturity: 5 /10 /15
- Additionally, these gilt-edged securities provide safety due to the zero income default, 100% liquidity, and bulk investment opportunity owing to the high rate of return.
2. Corporate Securities
- Corporate securityidentifies and effectively mitigates, at an early stage, any developments that may threaten the resilience and survival of a corporation. It is a corporate function that oversees and manages the close coordination of all functions within the company that is concerned with security, continuity, and safety.
- Corporate securities or company securities are known to be the documentary media for mobilising funds by joint-stock companies.
- The need for corporate securities arises in the following:
- Successful establishment of business functions
- Sponsoring of fund – intensive expansion plans
- There are two types of corporate securities:
- (a)Ownership Securities consist of preference shares and equity shares. Preference shares are those shares which carry priority rights related to dividend payment at a fixed rate and repayment of capital, in the event of a company being wound up. The advantages of preference shares include mobilizing funds from investors who prefer stable earnings with assurance, flexibility in the capital structure as desired, complete control of business transactions within an organization, and an increase in the profits of the shareholders. Disadvantages include not allowing investors to carry voting rights, shares being expensive, income tax problems, and redemption issues at the time of depression.
Equity Shares are ordinary shares, devoid of special attributes to dividend or return of capital, as in preference shares. Equity shareholders are the residual claimants against the assets and income of the corporation.”The financial risk is more with equity share capital, also called ‘risk capital.’ Some of the advantages of these shares are long shelf – life of funds, shareholders’ right to participation in the affairs of the company, an increase in shareholders’ assets, and ownership rights of the shareholders.
(b) Creditorship Securities are also called debentures and account for the debt of a company. Debenture holders are regarded as the creditors of the company and debentures account for the borrowed capital. A debenture may be defined as an instrument executed by a company under its common seal, acknowledging indebtedness to an individual or a group, to secure the sum advanced. Debentures are usually bonds issued by the company in a series of fixed denominations such as Rs. 100, Rs. 200, Rs. 500, Rs. 1,000 face value and are offered to the public, through a prospectus.
What are the types of financial institutions?
- Established in 1988 and provided statutory powers in 1992, the Securities and Exchange Board of India (SEBI) is the regulator for the Indian security market.
- The Indian Parliament passed the SEBI Act on 12 April 1992.
- SEBI is headquartered in Mumbai, Maharashtra.
- Before the Government of India enforced the existence of SEBI, the Controller of Capital Issues was the regulatory authority.
- The main motto behind constructing SEBI was to regulate and control the function of capital markets in India under the intervention of the Indian Government.
- The SEBI is managed by
a) The Chairman – nominated by the Union Government of India.
b) two officers from the Union Finance Ministry,
c) one member from the RBI and five members nominated by the Union Government, among which three should be whole-time members.
- The present Chairman of SEBI is Mr. Upendra Kumar Sinha, who replaced C. Bhave in 2011.
- The Preamble defines SEBI’s immediate responsibility to protect the interests of the investors, promote goodwill, usher development, and regulate proceedings of the securities market.
- SEBI caters to the needs of the security issuers, the investors, and the market intermediaries.
- SEBI also has additional responsibilities to draft SOPs and regulations (legislative), conducts investigation and verification for proper enforcement (executive) and passes rulings and orders (judicial)
- To streamline, regulate, and monitor its duties, the SEBI has been bestowed with the following powers:
- (i)To approve by-laws of stock exchanges;
- (ii)To instruct stock – exchanges to modify their by-laws;
- (iii)To inspect the accounts and ledgers and call for periodical returns from major stock exchanges;
- (iv)To inspect the accounts and ledgers of financial intermediaries;
- (v)To register brokers after validating their background verification.
- Some of the important SEBI Committees are the Primary Market Advisory Committee (PMAC), Secondary Market Advisory Committee (SMAC), Mutual Fund Advisory Committee, and Advisory Committee for the SEBI Investor Protection and Education Fund
- II. DFI
- A Development Finance Institution (DFI) is a subsidiary financial establishment which includes microfinance institutions – agencies which sponsor budding entrepreneurs and small businesses, especially in the semi-urban areas which lack access to banks and related services; community development financial institution which provides credit and financial services to the deprived markets and populations and revolving loan funds, which assists micro, small, medium and rural projects by providing loans to individuals who do not otherwise qualify for conventional financial benefits.
- Some of the important characteristics of these institutions are providing credit in the form of higher risk loans and equity positions.
- DFIs are commonly seen in developed countries, supported by the states.
- For markets with severe restrictions and lack of financial access, DFIs are very useful for providing finance for inclusive growth and development.
- In 1947, shortly after Independence, it was observed India’s capital market was relatively underdeveloped due to a lack of policies, benchmarks, and service providers. However, the demand was relatively high. To add to the woes, there were no merchant bankers or underwriting firms and neither were proper commercial banks to provide long – term investment options or portfolios.
- Against such a backdrop, the Industrial Finance Corporation of India (IFCI) was constituted on July 1, 1948. IFCI, at its inception, was meant to provide access to cost-effective funds through the Central Bank’s Statutory Liquidity Ratio (SLR).
- IFCI thus became an India Government-owned development bank to provide long – term financial leverage to the industrial sector.
- IFCI’s contribution to the modernization of Indian Industry, export promotion, import-substitution, entrepreneurship development, pollution control, energy conservation and generation of both direct and indirect employment is noteworthy.
- IFCI was reinstated as an organization in 1993 (under the Companies Act, 1956), to impart a higher degree of operational benefits, and access the capital markets directly.
- With effect from 1999, IFCI changed to IFCI Limited.
- The modus operandi of IFCI Limited was to facilitate provision for medium and long term financial support to large scale industries, especially when banks do not have the authority for an undertaking or issuing shares.
- Some of the vital responsibilities include providing loans and advances to major industrial projects, facilitating loan sanction in domestic and international currencies, underwriting the issue of stocks, bonds and shares.
- ICICI, an acronym for Industrial Credit and Investment Corporation of India, is a multinational banking and financial services company, based out of Mumbai and registered office in Vadodara.
- Over the years since its inception, ICICI Bank has accumulated several accolades. In 2014, it was declared as the second-largest bank in terms of assets and third in terms of market capitalization.
- Out of the vast portfolio of products and services, few worth mentioning is investment banking, life insurance, venture capital, and asset management.
- The ICICI empire has a network of 4450 branches and 13995 ATMs in India and is globally present in 19 countries.
- Along with giants like SBI, PNB, and BoB, ICICI is noted among the big four banks of India.
- ICICI Bank was established by theIndustrial Credit and Investment Corporation of India (ICICI), an Indian financial institution, as a wholly-owned subsidiary in 1994. The parent company was formed in 1955 as a joint-venture of theWorld Bank, India’s public-sector banks and public-sector insurance companies to provide project financing to Indian industry.
- ICICI was the first Indian bank to be enlisted under the NYSE in 1999, is a non – Japanese institution.
- Over the last two decades, ICICI has witnessed several important mergers with other banks and private partners to consolidate its business foundation.
- As a stalwart, it influences regulators such as the National Stock Exchange, the Credit Rating Information System of India Limited, National Commodities and Derivatives Exchange Ltd. And NABARD.
- Some of the vital portfolios include ‘Money2India’ – an online money transfer and tracking facility provided to non-resident Indians by the bank, ‘Extra Home Loans’ – mortgage – guaranteed supported loans for retail customers aiming at purchasing their homes in the economical housing segment, ‘Smart Value’ – the automated system of 24X7 lockers, including weekends and wee hours; ‘Saral Loans’ – to provide loans at a nominal rate of interests to the rural folks, including women; ‘Video Banking for NRIs’; ‘Contactless Debit and Credit Cards’ and ‘iWish’ – the flexible recurring deposit scheme to allow customers deposit feasible amounts of their choice each month.
- ICICI is a brand known for its CSR initiatives like the ‘Go Green Initiative’, ‘Jiyo Khulke’ contest, and ‘Read to Lead.’
- A noble lady, a visionary, ICICI’s CEO, Chanda Kochhar is one of India’s most powerful corporate tycoons, in recent times and has been influential in creating the success story. Some of her milestones are appropriate case studies for inspiring the youth.
- Under Kochhar’s leadership, ICICI has won the title of the ‘Best Retail Bank in India’ thrice consecutively.
- However, amidst such appreciation, ICICI has been criticized for several money laundering scams and inhuman debt recovery methods using goons.
- V. IDBI
- The Industrial Development Bank of India, as it was formerly known, is a government-owned financial service company, headquartered in Mumbai.
- The main motto behind its establishment was to supply credit and financial stability to the Indian industrial sector.
- With 1853 branches and 3350 ATMs, IDBI is the world’s largest bank and is a significant player under the aegis of commercial banks owned by the Indian Government.
- The Bank has an aggregate balance statement of INR 3. 74 trillion, at the closure of the last Financial Year.
- IDBI is classified as a development bank. Turning the pages of history, development banking emerged after the Second World War. India had a fair development banking system and was mainly targeted towards financing short – term capital requirements of the industrial projects. On the contrary, DFI – listed institutions like the NABARD, SIDBI, and NHB, were catering to the long – term financing requirements, under the RBI guidelines.
- In 1976, the statutory ownership of IDBI was transferred to the Government of India, which was initially a wholly-owned subsidiary of the RBI, since the inception in 1964, under an Act of the Parliament.
- IDBI can be accounted for the various reforms during the 1964 – 1991 period and has assisted in setting institutions like the Securities and Exchange Board of India (SEBI), National Stock Exchange of India (NSE), the EXIM Bank and the Small Industries Development Bank of India (SIDBI).
- With the Industrial Development Bank (Transfer of Undertaking and Repeal) Act, 2003, IDBI was bestowed with the status of a limited company viz., IDBI Ltd. Shortly thereafter, IDBI was incorporated as a ‘scheduled bank’ under the RBI Act, 1934.
- IDBI, just like ICICI has been crowned with many jewels; one worth mentioning is Dun & Bradstreet’s rating of the ‘Best Public Sector Bank’ in 2011, a period where customers were dissatisfied with the offerings of the government banks.
- Kishor Kharat is captaining the ship, being the CEO and MD.
- Some of the important portfolios include consumer banking, corporate banking, investment banking, mortgage loans, wealth management, and private equity.
INFLATION AND DEFLATION
What is inflation?
- According to the economics concept, there might arise a condition where there is a steep increase in the general price of goods and services, over a while. During such a crisis, a conventional currency unit buys lesser goods and services. Thus, there is a reduction in purchasing power and affordability. Also, the currency value might dip and this could hit export and import and wreck and economy.
- The positive effects could be the reduction of debt of the public and the private sector, keeping nominal interest rates above zero, so that the central banks can adjust interest rates to stabilize the economy and reducing unemployment.
- However, the negatives weigh more. Inflation creates a major set – back for investment and savings, production, and promotion, thereby resulting in a shortage of goods and resources. In a way, the opportunity cost of holding money, increases.
- The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI), and GDP deflator are some of the examples of broad price indices.
- Inflation does not only increase prices of commodities such as food and fuels but also hike prices of financial assets (stocks, bonds), tangible assets (such as real estate), services (healthcare and education) and manpower resources (labour).
- For calculating the inflation rate, the percentage rate of change of price index over some time needs to be gauged.
- To study the effects of inflation, Robert Gordon’s triangle model can be utilized. As per the study, there are three types of inflation, namely:
- (a)Demand-pull inflation: There is an increment in the aggregate demand, due to an increase in the public and private spending. A typical example is the kind of disposable income that youth today are exposed to. However, demand inflation encourages economic growth since excess demand privileges investment and expansion.
- (b) Cost-push inflation: Also called ‘supply shock inflation.’ It is featured by a drastic fall in the overall output. A typical example would be that of insurance losses during the recession, due to fraudulence or disasters.
- (c) Built-in inflation: Such inflation is ushered by adaptive expectations, related to the price/wage spiral. The price/wage spiral is a humongous cyclic process, where wage increase, increases the price. It could happen either because business owners try to push profit margins from rising expenses or the wage earners try to push their nominal after-tax wages upward to maintain equilibrium with the rising prices.
- Inflation can be checked if the economic growth is at par with the increase in the money supply. Some of the allied factors are an investment in market production, infrastructure, education, healthcare, wherein investment should be hiked; even defense.
What is deflation?
- Deflation is a commonly witnessed economical picture when improvements in production efficiency, lower the overall price of the goods. In such a condition, the hard currency per headcount drops, in effect making money scarce.
- Generally, deflation is a detriment in the price level of goods and services. A 0% (negative inflation rate) is also called deflation.
- Economists believe that deflation increases the debt value, leading to recession and hence does not endorse it.
- In the IS-LM model, a fall in the aggregate level of demand can cause deflation, due to a shift in the demand-supply curve for the goods and the services. As the prices of goods fall, consumers tend to delay purchase decisions which in turn hampers the overall economic activity. This condition also negatively affects investments and product innovation. Such a condition is called the deflationary spiral.
- There was inflation during World War I, but deflation returned immediately after the war had ended, almost close to the 1930s Depression.
- Ideally, deflation might also result from an in equilibrium; i.e. the supply of goods going up and the supply of money coming down.
- Demand-based deflation is categorized as follows:
- (a) Growth Deflation: A deflation resulting out of decease in the production and distribution cost of the goods and services, accompanied by competitive price cuts, resulting in demand rise.
- (b) Cash Deflation: A decrease in the overall consumption to save money, leads to a decrease in the velocity of money, otherwise termed as cash deflation.
- The most dangerous impact of deflation is non – investment or reduced investment.
- Deflation can be controlled by special liquidity policies to be strategized by the central banks, alongside regulating the value of the capital assets.