Elementary Economics

Even the government sells policies

Previously we learnt how Central Banks print money and increase/decrease money supply in the economy. Unlike Central bank Government cannot print money. Since Central bank is an autonomous body it is not under any obligation to follow Government orders/directives. In such a scenario, how do Governments increase/decrease money supply in the economy, independent of Central bank’s actions? Read on to know more.

From our article on measuring GDP, we know that both consumption by households and Government expenditure on public goods are used in calculating GDP. As consumption and/or Government expenditure increases, GDP also increases. In order to know more about how government increases/decreases money supply, first we need to understand consumption and government expenditure in detail. Consumption is contingent on income and higher the income, higher will be the consumption. Let us assume X’s salary per month is Rs.50,000 and the tax rate on the same is 10%. Assuming no tax exemption limits, X will receive a post tax income of Rs.45,000 (50,000 – 10%*50,000) every month which can either be saved or consumed. Now if the Government increases tax from 10% to 30%, X’s post tax salary will reduce to Rs.35,000 (50,000 – 30%*50,000). So automatically X’s ability to consume goods and services will also go down.   

The above example explained the effect of change in tax rate on an individual’s consumption and saving patterns. Apart from income tax which is a direct tax, 2 other indirect taxes – sales tax and service tax can also affect consumption patterns. Sales tax refers to the tax that we pay whenever we buy any goods. Service tax is the tax paid when we avail services in places like restaurants, saloons, cinema theatres etc. If the Government increases these indirect taxes automatically all goods and services will become more expensive and automatically consumption levels will drop down leading to lower GDP. On the contrary  decrease in tax rate will make goods and services cheaper, leading their increased consumption. This results in higher GDP.

Government expenditure includes building schools, roads, bridges, ports etc. It also includes expenditure on social welfare schemes as well as salaries paid to various government employees. Whenever Government increases its expenditure, it results in creation of more public goods or higher allocation to welfare schemes like education or healthcare. This leads to increased income for labourers building the road, teachers in the school or hospital workers. So we can conclude that increased Government expenditure puts more money into the hands of the people or increases their income, leading to higher GDP.  

When government increases expenditure and reduces tax rate, it acts as a double booster and transfers more money to individuals. This results in increased consumption and higher GDP. Such policies are called expansionary fiscal policy. On the other hand, increasing tax rate and reducing Government expenditure, takes away money from individuals, lowering consumption and GDP. Such policies are called contractionary fiscal policy.

This can also be understood through Government’s deficit. Tax represents Government’s income and and it’s spending is the amount invested in creating public goods and implementing welfare schemes. . If the Government is spending more than what it earns, it will have a deficit. If the deficit is expanding, it could be because of increasing expenditure, decreasing tax or both. In such cases, Government is following an expansionary fiscal policy. Similarly, if Government deficit is decreasing, it is following a contractionary fiscal policy.

Types of Deficits

Learn about economic credit cards

Every day in newspapers we keep reading about various government deficits going up/down or international agencies commenting on India’s high fiscal deficit or India relying too much on foreign funding. In order to understand these statements, let us discuss various types of deficits which are important to understand and track.

Current Account Deficit: Suppose there is a small village called Farmville. Most of the people in Farmville are farmers and they all grow wheat. All other items that villagers need will have to be bought in from other villages and cities. Shopkeepers in Farmville go to other cities/villages and buy items that can be sold in Farmville. Similarly Farmville’s farmers also travel to other cities/villages to sell the wheat that they have grown. Let us call all goods bought from other places into Farmville’s boundaries as imports. All wheat that crossed Farmville’s boundary and got sold in other places will be regarded as exports. Current account deficit is the difference between value of imports and exports. If total goods bought by residents of Farmville are worth Rs 10,000 and wheat sold outside of Farmville is worth Rs 8,000, then current account deficit of Farmville is Rs 2,000. If imports are greater than exports, the difference is referred to as current account deficit of a country. On the other hand, if exports are greater than imports, the difference is referred to as current account surplus.

Capital Account Deficit: Let’s consider a similar example. Suppose there is a city called Capitalia. It’s a fast growing city and all the companies are opening their offices in this city. It represents a very good investment opportunity and many people who are not living in the city, might want to invest in things like housing, restaurants, small business etc in the city. Thus, a lot of money will pour in from other cities. At the same time, people working in the city might send money back to their hometowns or some residents of Capitalia might invest in other cities. If the total money going out of the city is more than total money coming in, the difference is called capital account deficit. On the other hand, if total money coming in is more than total money going out, the difference is called capital account surplus.

Fiscal Deficit: It is very easy to understand this concept, if we take the example of Prateek. Prateek earns Rs 10,000 on a monthly basis, but has a habit of spending much more. Every night he goes out to party and on an average spends around Rs 30,000 a month. He can do this, only if he borrows Rs 20,000 every month from someone else. Thus, Prateek’s expenditure is more than his income and difference is called as fiscal deficit. Now replace Prateek with the government of a country. Government gets its income in the form of taxes from citizens and spends this money on various public projects and schemes. If Government’s expenditure is more than its income, it also needs to borrow in order to fill the gap. This difference between expenditure and income is called fiscal deficit and it represents the Government’s borrowing requirement.

Money

If someone wants to borrow INR 1,000 for a day and promises to return INR 10,000 the next day, you might not believe him, as magic only happens in Harry Potter movies. But if that someone is a bank, you better take it seriously. The article below explains how this magic works.

Suppose there were no banks in the city you live in and the first bank opened today. You went to the bank and deposited INR 1000. As per Government regulations, banks need to set aside at least 10% of the deposit amount as reserve and rest can be lent out. It is easy to understand why Government would want such a rule. If banks lend out the entire deposit amount, it will have none left to meet depositor’s withdrawal requirement. Thus, banks retain some part of the money to meet their liquidity requirements, before lending out the remaining amount. We will learn more about this percentage requirement in future articles.

Let’s come back to our example. You deposited INR 1000 with the bank, bank retained INR 100 (10% of 1000) and loaned out the rest to a company seeking a loan of INR 900 to fund its capital requirement. Company utilised this amount to buy tools and machinery, from a capital supplier, for its new plant. This supplier, after receiving the money from company, went to the same bank again and deposited INR 900.  In this roundabout way, money again came back to the bank in the form of deposit, but it was 10% lesser than the original deposit amount. The below chain explains this process.

Now again as per Government rule, bank will have to retain 10% of the deposit and can lend rest of the amount. This time bank will retain INR 90 (10% of INR 900) and will lend out only INR 810. Let’s suppose bank lent INR 810 to a farmer, to buy seeds and fertilizers. The farmer bought these from a fertilizer manufacturing company. The company, after receiving payment from the farmer, returns to the  bank to deposit the money. Thus money again came back to the bank in the form of deposit, but it was 10% lesser than the deposit amount of INR 900. The process can be seen in the following flow chart.

This process will keep on repeating. Every time bank receives a deposit it will retain 10% of the deposit amount and lend out the balance.Sum of all these deposit amounts (INR 1000+ INR 900 + INR 810 …) will add up to INR 10,000. As discussed in the beginning, if banks say they will convert INR 1000 to INR 10,000, you better take it seriously. This shows how small amount of money injected into the economy results in economic activity worth many folds larger than the amount injected.

Let’s learn more about money and the role played by central bank in the whole process.

 

Circular Flow of Products

How you control the entire production process

Market is a very common term used by all of us on a daily basis. Any place enabling buyers and sellers of a particular good/service to interact with each other is called market. If there is a place where buyers and sellers of sugar are coming together and trading with each other, it will be called a sugar market. Similarly, if buyers and sellers of furniture are trading with each other on an online portal, then that portal is also a furniture market.

Suppose you want to set up a cloth manufacturing unit. First thing that you would need is a piece of land to setup the factory. Once you have the land, you need capital. By capital, we are referring to related infrastructure like factory building, machines and software systems. Finally, you would be needing people to work in your factory, called labor. These are the three essential things that are always required for production and are called factors of production. Now the next question, where will you obtain them from? You would be buying these factors from other individuals. You can very well argue that you can buy them from other firms as well, but ultimately somebody would have bought it from individuals.

Let’s divide the whole economy into two parts, firms and households. All land, capital and labour ultimately belongs to households, let’s consider these households as individual families. Firms will be buying these 3 factors of production from households. So we have firms who are the buyer’s, households are the seller’s and factors of production as the product. As per our definition of market,  this setup would be called a factor market.

Let’s now revisit our example where you were trying to setup a cloth manufacturing unit. Suppose, now the factory is set up and you begin manufacturing. Who will buy your products? Again it’s the households (individuals) who would be buying your products in the cloth market. Let’s broaden our example and think about who would be buying all the finished goods manufactured in the economy, it will be the households who would be buying these products. Thus, in finished goods market, firms are the sellers and households are the buyer’s.

As we saw, firms buy factors of production from households in factor market. Then they manufacture finished goods using these factors of production and sell it back to households in finished goods market. Full circular process can be seen in the figure below.

Let’s now try and understand how money flows in the whole process.

Real Interest Rate

It's all relative

We recommend you read our post on inflation, as the discussion there will be very helpful in understanding this article. Interest rate is one of the most common economic terms that we use in daily life. Simply put, interest rate is the return earned on money lent out. So if you lend Rs 100 to your friend and ask her to give back Rs 110 after one year, interest rate charged by you is 10%. Similarly, if you put Rs 100 in your bank account, the bank will pay interest as in this case it’s the bank who is taking money from you. If the bank offers an interest rate of 4%, then after one year you will get Rs 104 from the bank and will earn Rs 4 as interest.

This interest rate that we just discussed and the ones that we generally hear & read about  is called the nominal interest rate. Now let’s see why nominal interest rate is not very relevant. The basic motive behind investing money is to earn returns/interest that allows us to retain purchasing power as well as to grow the savings kitty. This should allow us to improve our standard of living over a period of time. Let us consider an example. Suppose, you have Rs 1,00,000 and want to buy a high-end motor bike costing Rs 1,08,000. You decide to invest your money in a fixed deposit at 9% interest rate. You thought that you will have Rs 1,09,000 at the end of the year and will easily buy your favourite bike.

But after one year, you realize that the price of the bike has gone up to Rs 1,15,000 (increased by approx 6.5%). You are sad, as again you cannot buy the bike. What really happened here? Due to general inflation of around 6.5% in the economy, price of the bike increased proportionately during the course of the year. So in order to achieve your target of buying the bike you should have invested in an instrument that returned 15%  after a year. That would have allowed you to beat inflation of 6.5% and in addition earn real returns of 8.5%.

Real Interest Rate = Nominal Interest Rate – Inflation Rate

In our example nominal interest rate is 9% and inflation is 6.5% and hence real interest rate is 2.5% (9%- 6.5%). When we invest our money, some part of what we are earning is always being eaten away by inflation.

Investors will be able to retain their purchasing power only when they earn returns equal to or more than the inflation rate. Suppose the inflation rate is 9% and interest rate is 8%, in real sense you will actually lose 1% of your money, rather than gain anything. So rather than being able to buy more things after a year, you won’t even be able to buy the same basket of  goods bought earlier, as their market price will be higher than your investment kitty.

Compared to savings bank accounts, fixed deposits, bonds and other instruments, only equities as an asset class have generated positive real rate of return in the last decade. To make money in real sense over the long term, invest in equities.

Gross Domestic Product

It's not just size, growth also matters

Gross Domestic Product (GDP) is the most common measure to estimate the size of a country’s economy. It represents the total value of final goods and services produced domestically, in a given time period. India’s GDP was approximately USD 2.3 trillion for financial year 2015. What this means is that the total value of final goods and services produced inside the geographical boundary of India between April 2014 and March 2015 was USD 2.3 trillion.

GDP calculation only includes value of final goods and services, as the value of intermediary goods & services will automatically be included in the final price. For example, GDP doesn’t include the value/price of a computer chip, as the same is included in price of a computer when it is sold. When calculating GDP, all end goods and services manufactured within the country is considered, regardless of the country of origin of the manufacturing company. So the value of a Samsung mobile manufactured in India will be included in GDP, even though Samsung is a foreign company.

GDP growth rate is the percentage change in GDP, compared to the previous financial year. It is commonly used to see how many additional goods and services were produced, compared to the previous year. It is also helpful in comparing two different economies. If GDP growth rate of India is 7.5% and that of China is 7.0%, it means that Indian economy is expanding faster than China’s. However, this does not tell us anything about the overall size of the economy – which is measured by the absolute GDP number.

Let us consider a small example to understand this.

Suppose, last year, India’s GDP was USD 1000 and GDP of china was USD 10,000. This year, GDP growth rate of India is 9% and that of China is 6%. This means, the value of additional goods and services produced by India is USD 90 (9%*1,000) and that in China is USD 600 (6%*10,000). Thus, we can say that India is expanding rapidly, but the absolute value of additional goods and services, produced by India, is still less than China’s because of China’s higher base (previous year’s GDP).

GDP per capita is defined as the total GDP divided by the total population. A higher GDP per capita signifies a higher living standard, as more number of goods and services are available for each individual within the country.

Foreign Currency Reserves

A dollar is what I need

We strongly recommend reading our articles on Forex, before starting with this one. Here, we will try to explain what are foreign currency reserves and how are they accumulated.

Let’s start with an example. Suppose there are two countries: Dorne and Vale. Dorne’s currency is D$ and Vale’s currency is V$. Currently the exchange rate is 1D$ = 2V$. So for every D$ desired by the citizens of Vale, they will have to pay 2 V$. Dorne announces some new economic policy and the country suddenly becomes a hot investment destination. After these new changes lots of people from Vale want to invest in Dorne. This will increase the supply of V$ in the forex market, and demand for D$ will increase. We know that when demand for a product increases, its price rises. So the price of D$ will increase. Let’s say the exchange rate moves upto 1D$=4V$. Again as we learnt in our article on FX, this appreciation of D$ will make Dorne’s exports costly, as Vale’s citizens will now have to pay more V$ to buy the same amount of D$.

In our article on Central bank, we learnt that managing volatility in forex market and printing money are among the important functions of a central bank. In the above example, appreciation of D$ occurred because supply of V$ increased against D$. Let’s say Dorne’s central bank doesn’t like this and starts printing more D$ to pump into forex market in order to buy and absorb increased supply of V$. As the central bank starts buying V$, with the newly printed D$, it will start accumulating V$. This accumulated pie of V$ is called foreign currency reserves.

Now let’s understand why these foreign currency reserves are very important. Suppose suddenly the situation in Dorne turns bad due to collapse of the Central Government and now all the citizens of Vale, who had earlier invested in Dorne, want to pull out their investments. All of them will start selling D$ to convert it into V$, which they can take back to Vale. This will increase the supply of D$ in the forex market. Again as the supply increases we know that price of D$ will go down and it will depreciate against V$. Dorne’s central bank doesn’t want that to happen. So it starts selling V$ from its foreign currency reserves to buy D$ and increase the demand to match supply. In this way it will be able to control excessive depreciation of its currency.

When the central bank of a country tries to control excessive currency appreciation, through printing its own currency, in order to buy foreign currency, it ends up building foreign currency reserves. It can use these reserves to control excessive depreciation of its own currency – by selling foreign currency from reserve and buying its own currency. But the important point to note is that there is no limit upto which a Central Bank can print its own currency. However foreign currency reserves held by the bank are limited. So the extent upto which a central bank can protect its currency depreciation depends on the level of foreign currency reserves it holds.

Now, let’s understand the role played by foreign currency reserves in balance of payment.

Central Bank

The big boss

Central Bank is the single most important unit in the whole financial system. It is very easy to understand the need and importance of a central bank. You must have seen a football or a wrestling match. Ever tried to imagine what would happen if the referee is not present? In wrestling, a wrestler can easily cheat and use wrong moves to defeat his opponent. Similarly, in a football match, a goal might be claimed, even if scored after offside. Central bank is the big boss and can be considered as referee of the banking system. The Central bank drafts rules that all participants of the system need to adhere to and ensures implementation of these rules.  

Let us reconsider the example that we discussed in our previous article. We understood everything about how money flows within the system and its multiplier effect, but we still don’t know how money came into your hand, in the first place. It is the central bank of a country that has all the rights and power to print money. A currency note is a promise by the Governor of central bank of India that he will pay you the same amount of money in exchange for this note. Suppose, I write on a stamp paper that I will give INR 1,000 to the holder of this stamp paper and pass it on to you as a gift. You owe INR 1,000 to your friend Neha and decide to pay her using the stamp paper, which can be converted to money any time. Neha accepted the stamp paper and decided to buy groceries using the same and passed it on the shopkeeper, who in turn used it for some other purpose. This is how paper currency got accepted in the society and circulation began.

So far we have discussed two important functions of the Central bank. First one is to draft and implement regulations for the banking system. Central bank decides criteria regarding who should be allowed to operate a bank, minimum documents required to open a bank account, amount of money banks should hold as reserve to safeguard depositors money in case of crisis etc. They provide a level playing field to all banks and also ensure that customer interest is safeguarded. The second function of Central bank is to print money.

In addition to this, central bank is also responsible for controlling inflation in a country. As discussed previously, inflation can be of two types: demand pull and cost push. If central bank prints too much of money and this extra money flows into the system, it will result in a case of too much money chasing too few goods. This is exactly what happens in the case of demand pull inflation. So when inflation is high, central banks reduce injecting money into the economy. When inflation is low central bank pumps more money into the economy to drive up inflation. As discussed earlier in our article on forex, if central bank prints too much money thereby increasing its supply, the currency will depreciate and its value will come down. Too little printing can lead to appreciation of currency as well. Thus, another important job of the central bank is to control currency fluctuations in the forex market.

To conclude central banks are the big boss of the banking system, they design rules of the game, ensure all banks follow the same, control money supply, target inflation and closely watch and safeguard the economy against unwanted currency fluctuations.

Read on to understand how central banks inject money in the economy.

Circular Flow of Income

Spend.. it's all coming back to you

In the previous article, “Circular flow of products” we saw how products flow in the economy. Firms buy factors of production from households in the factor market and sell finished goods back to them in the finished goods market.

When firms buy factors of production (land, capital and labor) from the factor market, they need to reimburse households for the same. Thus, in factor market money is flowing from firms to households. Money spent by firms is their cost of production and earnings for the households. In the finished goods markets, firms are selling their products to households, so money is flowing from households to firms. As shown in the diagram below money and products flow in opposite directions, money moves clockwise and products flow anti clockwise. The cumulative amount spent by households is equal to the revenue of the firms. The difference between the amount earned by firms in the finished goods market and the money spent by firms in the factor market is the firm’s profit.

The diagram also makes it obvious that expenditure of one entity is equal to total income of another; applying the same working to the entire economy, total expenditure in the economy is always equal to the total income.

Let’s talk a little more about the income received by households. In the factor market, households earn various kinds of income from firms. Income received for renting out land is termed rent. In return for labor provided by household’s, they receive salary/wages and capital earns interest. It is easy to understand how land would earn rent and labor would earn wages/salary, but understanding how capital earns interest is a little difficult.

Let’s now see how capital, which we earlier defined as machinery, tools and technology earns interest for households.

Value of Currency

Why currencies rise and fall

Foreign exchange market (FX, currency market) can be thought of as a global network of banks and financial institutions, selling and buying currencies from each other; an Indian bank buying Dollars by paying in Rupees, a European bank buying Rupees by paying in Dollars etc. Suppose you are planning a trip to Australia and need Aussie Dollars for being able to buy goods and services in Australia. You can go to your local bank like HDFC/ICICI or a currency dealer and can buy Aussie Dollar by paying in Rupees. Instead of an individual, suppose there is an Indian automobile manufacturer who wants to import auto parts manufactured in Japan. The company will have to pay in Japanese Yen to buy these auto parts. So it will buy Yen from a bank or a dealer by paying in Rupee and then pay Yen to the company from which it is buying these parts. Just like you and this company, there are hundreds of thousands of individuals and companies around the world seeking foreign currency for various reasons. They go to their banks and dealers for their needs and these banks and dealers deal with each other to fulfil the needs of such individuals and companies. Hence currency market can be described as an interconnected network of these institutions.

Every day in the newspapers, we keep reading that currency is falling or that the government is doing nothing about currency deprecation etc. The natural question is why is this so important that it needs so much of our attention and why does currency actually fall or rise? First, let’s discuss the second part of our question. Just like other goods and services, price of a currency is also determined by its demand and supply. Suppose today price of USD 1 is Rs 62. Now assume, lot of Indians suddenly start travelling to USA or many Indian companies start buying products from the USA or many Indians start investing in the US in the hope of better opportunities, all these activities will lead to greater demand for US Dollars from India. We have already learnt that  as demand for a product/service increases, price of the same also increases. So now USD 1 becomes RS 65 ie we need to pay more, in order to buy USD 1. In this example, USD appreciated with respect to Rupee by 4.84% [(65-62)/62]. In an opposite case when demand for USD decreases, its price will decrease and we will have to pay less. Suppose USD 1 becomes equal to RS 60. In this case, USD depreciated with respect to Rupee by 3.23% [(62-60)/62]. It is important to understand that if demand for USD is increasing from India, it doesn’t mean that it’s increasing from rest of the world as well. So USD might not appreciate against other currencies, as its demand is increasing only against Rupee.

So when a currency appreciates, it means we need to pay more in order to buy 1 unit of the currency. Similarly if currency depreciates, we need to pay less in order to buy 1 unit. As you might have already noticed, price of one currency is given in another currency. In our example, price of USD was given in Rupee. So when one currency in the pair appreciates, another is depreciating simultaneously and vice versa. Let’s say initially USD 1 = INR 60 or 1 INR = 1/60 USD. Now USD depreciates. This means we will have to pay less to buy 1 USD. Suppose it becomes 1USD = 58 INR. So INR 1 becomes USD 1/58. Initially we had to pay USD 1/60 to buy INR 1, but now we will have to pay USD 1/58, which is more. Thus, Rupee appreciated when USD depreciated. Hence, we say that for a currency pair, if one currency is appreciating, the other depreciates and vice versa.

To understand the first part of our question, that why this appreciation and depreciation is so important, read on.

Inflation

Investing in FDs thinking you will earn 8% returns?

From an individual investor’s perspective, inflation is one of the most important indicators to understand and track. Inflation indicates an overall increase in the general price level of goods and services in a country. When we read that last year inflation was 7%, it doesn’t mean that price of every product like milk, cars, clothes, etc., increased by 7%. It means compared to the previous year  on average prices of all goods and services increased by 7%.

Each one of us would have definitely experienced the impact of inflation in our lives. In 90s, our overall college education fees never used to be more than few thousand rupees, but now it’s always in lakhs and crores. We know that since our childhood, prices of almost all goods and services have jumped manyfold. Let’s take a basic example:

2005: You have Rs 100 and price of a cigarette is Rs 5. You can buy 20 cigarettes with Rs 100.

2015: You have the same Rs 100, but the price of a cigarette has increased from Rs 5 to Rs 12. Now instead of 20, you can buy only 8 cigarettes.

This example clearly shows how inflation reduces value of money. Over a period of time, the same amount of money will buy less units of the same good, thereby reducing the individual’s purchasing power. Hence it is very important to invest one’s money and grow it.

Over the last decade, average inflation in India was around 8.4%. After-tax average rate of return on fixed deposits (assuming tax @ 20%) was around 6.2%. Thus, by investing in FDs you were actually reducing the value of your money by 2.2% every year, instead of growing it.

Now that we know what inflation is, we need to understand what causes it. Inflation depends on price, which is determined by demand and supply. So if people have more money leading to more demand than supply, price increases. This is called demand pull inflation and is caused by too much money chasing too few goods. On the other hand, if supply is less compared to demand, again prices increase and cause inflation. This is called supply push inflation.

During the last decade, average annual inflation in India was around 8.4%. After tax average annual rate of return on fixed deposits (assuming tax @ 20%) was around 6.2%. Thus, by investing in FDs you were actually reducing the value of your money by approximately 2.2% every year, instead of growing it. The rate of return on savings deposit account is always less than return on fixed deposit (FD) and interest rate on bonds are comparable with returns on fixed deposits. So after accounting for inflation, any individual who invested in savings account deposit, fixed deposits or bonds actually lost money in the real sense. During the same decade, stock markets generated an after-tax average annual return of 16%! Certainly makes sense to start investing in equity and stop losing money investing in bonds and FD’s.

Balance of Payments

It's a zero sum game

Reading our earlier posts regarding deficits and foreign currency reserve will help you understand this one better. In balance of payment, we are trying to account for all the transactions that take place between a country and the rest of the world. According to balance of payment theory, summation of current account and capital account will always be zero.

From our article on deficit, we know that current account deals with the exchange of goods and services between a country and the rest of the world. If the goods exported by a country to the rest of the world is more than goods imported by the same country from the rest of the world, then their is a current account surplus. On the other hand, if imports are more than exports, there will be a current account deficit situation. Let’s hypothetically assume that India’s current account deficit is INR 500 billion. It means that the value of goods imported by India from rest of the world is INR 500 billion more than goods exported out from India. On a net basis, we can say that India is receiving goods and paying money to the rest of the world. Thus, Rupee is flowing out from India in this case.

We defined capital account surplus as a situation where money coming into the country is more than money going out. This can happen with India if investment by rest of the world in India is more than what India is investing in the rest of the world. These investments can come in the form of foreign portfolio investment (FPI) or foreign direct investment (FDI). We will discuss FPI and FII in the next article. Important point to remember is that if you want to invest in India, you can do that only in rupee. Let’s assume that India’s capital account surplus is INR 550 billion. It means, on a net basis rest of the world is investing INR 550 billion in India.

You must be wondering how more money can came into the country, as only INR 500 billion had gone out via payment for imports and when other countries cannot print Rupee notes. Here foreign currency reserves of other countries come into picture. This extra INR 50 billion is coming in from Rupee reserves of other countries, i.e. total Rupee reserves held by foreign countries would have gone down by INR 50 billion. Keep in mind that total money going out will be equal to total money coming in plus change in foreign currency reserves of other countries. So if the money coming in is more than what is going out, the difference is being funded via foreign currency reserves of other countries.

Similarly if money coming in is less than money is going out, the difference amount is being retained as foreign currency reserves by other countries.

Read on to understand two most commonly used financial terms: FII and FDI.

Monetary Policy Instruments

The previous article details Central bank’s functions and it’s importance in the financial system. In today’s world, inflation targeting and control of money flow in order to ensure price stability takes precedence over all other tasks of the Central bank. The bank uses different processes and adopts various instruments to achieve this objective. Some of the  important ones are explained below:

Cash Reserve Ratio (CRR): Let’s again go back to the example where we understood how more money is created in the economy and how money multiplier works. As soon as a deposit was made, the bank was required to retain a certain portion of the deposit and was free to lend the balance amount. The percentage of deposit that the bank is required to retain is called “cash reserve ratio”. So if an individual deposits Rs 100 with the bank and CRR is 5%, banks need to retain Rs 5 in reserve and can lend rest of the money to borrowers. The main objective of CRR is to ensure that banks have sufficient cash, in order to meet withdrawal requirements of their customers. It works on the assumption that all depositors do not demand their money back on the same day and only a small percentage of the total population do so. In India, Reserve Bank of India (RBI) sets the CRR ratio and banks are required to deposit the same with RBI.  

Statutory Liquidity Ratio (SLR): It can be thought of as an addition requirement like CRR where banks are required to retain certain percentage of total deposits in cash and cash equivalents. The main objective of this exercise is to ensure that banks have sufficient liquid balance to meet customer’s demand for cash. Suppose funds are invested in real estate property or used to buy stake in a company, then it cannot be easily liquified. It will take time to sell stake in a company or sell land/real estate. However investing in gold or Government securities is prudent as these instruments can be readily converted to cash. Gold has a standard price and can be easily converted to cash by exchanging with other banks or selling in the market. Read more about Government securities below.

Open Market Operations: When individuals need funds, they can borrow the same from banks. This transaction involves promise of payback within a certain time period and payment of interest on the borrowed amount. Similarly when Government wants to borrow money, it does so by issuing securities called treasury bill/bond. Suppose Government wants to borrow Rs 1000, it can issue a treasury bond which promises pay back of Rs 1000 in 5 years and an interest rate of 8%. RBI handles Government’s borrowing activities. In open market operations, RBI either buys these securities from financial institutions like banks or sells it to them. If RBI is buying from banks, it means RBI is paying money to banks, which will then be loaned out thereby pumping more money into the system. If RBI is selling to banks, then banks are paying money and buying these securities thereby reducing the cash available to provide loans.This has the effect of sucking money out of the system.

Repo and Reverse Repo Rate: Just like individuals and governments, sometimes banks also need money to fulfil their cash requirements. In such cases they can borrow money from RBI. The interest rate at which banks borrow money from RBI is called repo rate. Sometimes banks also have excess cash and like to earn interest on it. In such cases they can park the money with RBI and earn interest on it. Interest rate received by banks for parking excess cash with RBI is called reverse repo rate.

 

Leakages in the Circular Flow

How your savings finance corporate investment

To complete our understanding of circular flow, lets now learn about leakages from the same. 3 new entities will now be introduced into the circular flow to explain how they create leakages.
1.Introducing Government

The first entity that is being introduced is Government and it is at the center of the circular flow. Government collects taxes from both individuals and firms. A part of the money received by individuals in factor market, in exchange for land, labor and capital, will be collected by the government as tax. Similarly, a part of the money received by firms in return for finished goods will be collected by the government as corporate tax. Government collects taxes so that the amount can be spent for public welfare by creating public goods. Public goods are goods and services available and useful to all members of the society. This usually includes roads, ports, railways, schools & colleges, hospitals etc.   

2.Introducing External Sector

External sector is linked to the finished goods market. Foreign entities buying finished goods manufactured in a country, say India, i.e. exports, results in injection of money into the economy. Similarly, Indians buying foreign finished goods, i.e imports, results in money flowing out of the economy.

3.Introducing Financial Sector

Financial sector is linked to the factor market. In our previous article, we mentioned that expenditure by firms on capital items like machinery, tools and technology in factor market results in interest income for households. Households earn rent and wages from factor market. A part of this earning is saved in banks for future needs and only remaining balance is spent in finished goods market. This act of saving, results in a leakage and money flows out of the circular flow. Firms borrow money from banks in order to fund their capital related expenditure. This way money is again injected into the economy and in the process firms pay interest to banks for borrowing money. Banks pass on some part of that interest earned to households, in return for parking their funds. Thus households are saving funds and depositing the same in banks. This kitty is then lent out by banks to firms, to fund their capital needs. So in a roundabout way households enable firms to buy capital and in the process earn interest. Banks facilitate the entire process.

Now that our understanding of circular flow is complete, we can easily use the same to learn how GDP is measured in any economy.

 

Currency Appreciation & Depreciation

Not too much, not too little.. just right

Let’s continue our discussion on currency market and movements that we started in our previous article. We just understood what a currency market is and why currency appreciates and/or depreciates. In this article let’s try to understand why this upward/downward movement of currency is so important.

Suppose you want to import a costly laser machine from USA. The cost of machine is USD 1000. Currently the conversion rate given to you by your dealer is USD 1 = INR 65. So as of today, you will have to spend INR 65,000 to buy this machine. Due to some issues, you postpone your purchase and decide to buy it next month. Meanwhile due to reasons beyond your control, USD appreciates. We know that USD appreciation means INR depreciation. Thus, we will have to pay more in order to buy each unit of Dollar. Now after one month, you again ask for a quote from your dealer and he quotes USD 1 = INR 70. Thus, you will now have to pay more to import the same machine because of USD appreciation (INR depreciation).

Let’s take another example. Suppose you manufacture cycles. You want to export one cycle to US for INR 6000. The person importing this cycle in US will have to pay in INR and thus asks for a quote from his dealer to buy INR. His dealer quotes 1USD = 60 INR. So to buy INR 6000, he will have to spend USD 100 (6000/60). Just as in previous example, he also faces some issues and postpones his purchase by one month. After one month, you are again willing to sell the cycle at INR 6000, but suppose USD appreciated. Now it becomes USD 1 = INR 65. Thus, the US buyer will only have to pay USD 92.5, in order to buy the same product.

Above examples make it very clear that when foreign currency appreciates (domestic currency depreciates), local goods become cheaper in other countries, as foreigners will have to pay less to buy the same amount of INR. At the same time, it makes foreign goods costly as you will have to pay more to buy each unit of foreign currency. So when local currency depreciates, imports become costly and price of exported goods becomes cheap for foreign nationals. As price of imported goods increases, demand for imported article decreases and as price of goods exported becomes cheaper for foreigners, foreign demand for local goods increases. Hence we can now conclude that domestic currency depreciation leads to higher exports and lower imports. Opposite will happen when domestic currency appreciates.

India is a major oil importer as it doesn’t produce sufficient crude oil to meet its energy demands. Thus when rupee depreciates, it becomes more expensive for the Government to import oil. Higher oil prices increases the overall price level, as explained in our article on stagflation. Thus, it becomes important for many countries to ensure that their currency doesn’t excessively depreciate. But if a country doesn’t import many things, then it would want local currency to depreciate, so that local goods become cheaper in other countries and exports increases. Countries with excessive focus on exports use currency depreciation technique to boost their exports.

Stagflation

Inflation's nefarious cousin

You just learnt about inflation and how it is important to invest in instruments that earn higher rate of return compared to inflation. Now let’s explore a similar sounding concept called stagflation.

Stagflation is a situation where economy is stagnating, i.e. it is not experiencing any GDP growth and at the same time there is also high inflation. It is a nightmare situation for any country, as high prices kill purchasing power and harm the poor, while low or negative GDP growth worsens the situation by causing unemployment.

Now the basic question is how does a country get into such a mess? There could be many reasons, but the concept of “supply shock” allows us to understand the causes of stagflation the best. Suppose tomorrow all oil producing nations decide to cut supply and suddenly there is shortage of oil everywhere. Obviously the price of oil will start increasing. Oil is the lifeblood of any economy as it is used in various activities like transportation, power generation, manufacturing of goods etc. Thus rising oil price will push up prices of all goods. Consider oranges, to get farm produced oranges to a far off market, there is a huge transportation cost involved which will increase with rising oil prices. Keeping this in mind, let’s look at the following flow chart:

FDI vs FII

Not all funding is good

First let’s understand each one of them separately and then compare to list the differences.

FDI (Foreign Direct Investment): If a foreign firm opens a manufacturing hub, research centre or any other unit in the form of a subsidiary in India, then the investment is classified as FDI. If a foreign company starts a new company in a joint venture with an Indian firm, it is classified as FDI. If a foreign company invests in a domestic Indian company to inject some fresh capital, again it is considered to be FDI. FDI is stable and long term money getting invested in the country. It helps in building new businesses which results in more jobs, higher GDP leading to increased prosperity. It also brings in product expertise and new technology of foreign company and helps in increasing efficiency.

FII (Foreign Institutional Investment): It consists of foreign money getting invested in the stock/bond markets of a country. A foreign company buying shares of Reliance on NSE, is an example of FII. The money coming in through this route is generally not a long term investment, as the investee company can sell shares anytime and take the money back to its own country. No new businesses are created from this money, as through FII route foreign institutions are buying shares already trading on exchanges and no new investment is flowing directly to the company. Thus FII funds just makes buying and selling shares on exchanges easy by increasing liquidity, however it does not help in creating new jobs by building new business or increasing the GDP. 

Both FDI and FPI are part of the capital account. FDI is a long term investment. For example Maruti Suzuki is a joint venture between Maruti and Suzuki. If tomorrow Suzuki wants to take the money back, it cannot do so by just pressing one button. At the same time, the joint venture has helped in creating so many new jobs and added to the goods produced inside the geographical boundary of India, increasing India’s GDP. On the contrary, let’s consider the example of Morgan Stanley buying shares of TATA Motors on NSE. This transaction does not help in getting access to any new technology, creation of new jobs or access to new funds for business expansion. Overall there is no contribution to the GDP. Thus FDI is always preferred over FPI.

Monetary Policy Mechanism

In the previous article we learnt about Central bank controlling money supply to the economy and the instruments at its disposal to achieve this objective. This article elaborates on how Central bank uses these tools to achieve its monetary policy objective.

Suppose a central bank wants to pump in more money into the economy. This is called expansionary monetary policy. Let’s see how this can be achieved using different tools:

CRR: This is the percentage of deposit that the bank is required to retain and maintain as reserve with RBI. Suppose current CRR is 6% and RBI reduces the same to 4%. The differential of 2% (6%- 4%) has now been made available to banks, they can now withdraw this amount and lend the same. Increased lending will lead to flow of money from banks into the economy, thereby accomplishing RBI’s mission.  

SLR: If the objective it to increase money supply then RBI can lower SLR. Suppose the current SLR is 18%, and RBI lowers the same to 15%. Banks can redeem the 3% differential amount and utilise the same for lending purposes. This extra money will flow into the economy.  

Open Market Operations: If the Central bank wants to increase money supply, it can buy back Government securities held by banks. This will put more funds in the hands of banks, which will then lend out the same leading to increased money supply in the economy.

Repo rate and reverse repo rate: Repo rate is the rate at which banks can borrow money from Central banks. If Central bank reduces repo rate, then banks cost of borrowing goes down. Suppose the repo rate drops from 7% to 6%, the 1% differential interest outflow that banks saved on can be utilised to lend to borrowers. Lower interest rates might also encourage banks to borrow more to lend. This will lead to more money flow into the economy.   

Reverse repo rate is the interest rate which Central banks pay other banks for funds parked with it. Lowering reverse repo rate, will lead to lesser interest earnings for banks. Hence instead of parking money with Central bank, banks will lend more to borrowers leading to increased money supply.

In a contrary situation, when central bank wants to take money out of the economy, it will reverse its decisions in all the above cases. So CRR, SLR, repo rate & reverse repo rate will all increase and Central bank will sell Government securities to suck money out of the system. This is called contractionary monetary policy.

Let’s now understand how central banks decide which economic policy, contractionary or expansionary, to pursue.

Measuring GDP

The recipe

Understanding how to measure gross domestic produce (GDP) becomes very easy after learning circular flow of income. We recommend reading our previous three articles on circular flow of products and money before continuing on. As discussed in an earlier article, GDP is the value of final goods and services produced domestically in a given time period. When we say GDP of India was USD 2.3 trillion in financial year 2015, we mean that total value of all goods and services produced in the Indian economy between April 2014 and March 2015 was USD 2.3 trillion.

In order to measure GDP, we need to calculate the expenditure incurred on producing all the goods and services. Obviously, goods and services produced in the economy will get consumed generating income for producers. From our previous article on circular flow of income we know that income is equal to expenditure. So if we can measure the total spending on goods and services in the economy, we will be able to arrive at the total GDP figure. Hence we can either use the total expenditure or total income approach to calculate total GDP.

Let’s discuss the expenditure approach. From the above diagram, we can see that there are 4 major spenders in the economy. Households are spending on purchasing goods and services produced by firms, firms are spending on their factor requirements, Government is spending to create public goods and finally foreigners are spending to buy domestic goods.

Total Expenditure = Household expenditure on goods and service (C) + Firm expenditure on capital and other factors (I)+ Government’s expenditure on public goods (G)+ Foreigners net expenditure on exports (X-M)

GDP = C + I + G + (X – M)

Here, C is the consumption by households, I is defined as the investment by firms, G is the government expenditure and X-M is export minus imports. This is how GDP is measured in the expenditure approach.

If any of the above 4 things increase, GDP of the country will also increase. If households are consuming more because of rising levels of income, then GDP will increase. If firms are investing more, because borrowing money has become easy due to low interest rates, then GDP will increase. If Government is spending more on public goods, then GDP will increase. Finally, if exports are rising faster than imports, even then GDP will increase.

The above concept will become clearer in the next posts. Read on.

Unemployment

One of the most dreaded words in economics

Employment is the primary source of income for majority of the people. If less number of people are employed, it results in less expenditure in the economy thereby leading to lower GDP growth. This will be explained in detail in our article on measuring GDP. Generally high unemployment rate signals recession and problems with the economy. Thus it is very important to observe and track unemployment levels in an economy to determine its health.

Let’s try to understand this concept with an example. Suppose, there is a tiny island called Wonderland. The total population of Wonderland is 30,000. Out of these 30,000 people, 5,000 are below the age of 16 which is the minimum working age on the island. So working age population on the island is 25,000 (30,000 – 5,000). Labor force includes all the people who are willing and able to work. So students, retirees, disabled people and homemakers won’t be included in the labor force. Most of the people whom we just mentioned are the ones who are not able to work due to various reasons, but labor force also excludes people who are not willing to work. There might be few people who are very rich; too lazy to go out for work; or just tired of searching for a job. These people are also not included in the labor force, as they are not willing or actively seeking to work. Let’s again assume that amongst the working age population, 5000 people are either not able to work or are not willing to work. So the island’s labor force, representing people who are able and willing to work, would be 20,000 (25,000-5,000). Now let’s understand labor force participation rate:

Labor force participation rate = (Labor Force/Population above the minimum working age)*100

In our example this would be 80% (=20,000/25,000*100). This represents the ratio of  willing and able to work people within working age population over total working age population.  Labor force consists of both – people who are employed and the ones who are not. A person is called unemployed if he is able and willing to work, but does not have a job right now. Unemployment rate is the percentage of people in labor force who do not have a jobs.

Unemployment rate = (Unemployed People/Labor Force)*100

Let’s say, in wonderland 2,000 people do not have a job, but are able, willing and actively seeking employment. Then unemployment rate would be 10% (=2,000/20,000*100). If after a year unemployment rate goes down to 5% and nothing else changes, it means many jobs were created last year due to which there are less number of unemployed people now. Jobs are created when new factories and production plants are setup. Factories are setup to produce more goods and services, and as we learnt in our first article, more goods and services translate to higher GDP. Thus, a low unemployment rate generally represents a healthy economy and vice versa.

Now let’s see how these variables change with change in business cycles, as an economy progresses.

Monetary Policy Decisions

In our previous article we learnt about how central banks achieve expansionary and contractionary monetary policy objectives. In this article, let’s discuss how central banks decide whether to pursue contractionary or expansionary monetary policy. But before that, we need to understand how central banks control interest rates. Let’s do this using an example.

You can probably recall the typical Zamindar and Lala characters in old Bollywood movies. They used to be among the wealthiest people in the village and anybody in need of money used to go to them for a loan. These villians used to take advantage of the situation and charge very high interest rate on the loan. Suppose there is a very wealthy Zamindar – let’s call him Z, and he lends money to less wealthy Zamindars in nearby villages. He charges 20% interest on loans. Less wealthy Zamindars borrow money from Z at 20% and lend out the same to people in their village at a slightly higher charge of 25%. The differential of 5% is the less wealthier Zamindars profit. Now suppose Z, decides to raise interest rate charged to 23% from 20%. The smaller Zamindars have choice of either raising interest rates and passing on the increased cost to the end borrower or they can decide against raising interest rate thereby making lesser profits.  

In our example, Z is the central bank and smaller zamindars are other local banks. We know that local banks borrow money from central bank at repo rate. So if central bank decides to increase the interest rate (repo rate), cost of borrowing funds increases for other banks. They pass this onto the end customer by increasing their lending cost. Similarly, when central bank reduces repo rate, cost of borrowing funds becomes cheap and profitability of banks increases. In such cases, banks might pass on the benefits to their customers by lowering interest rates on funds lent out. This is how interest rate increases everywhere when central bank increases repo and vice versa, and that is how central banks control interest rates.

As we learnt in our article on measuring GDP, GDP increases when investment by firms increase. When interest rates are low, cost of borrowing funds are cheap. When firms can borrow easily at cheaper rates, they increase their investments and this ultimately leads to higher GDP.

When economy is going through a recession and GDP is contracting, Central bank can help by adopting an expansionary monetary policy. As discussed earlier expansionary monetary policy, pursued through either CRR, SLR, open market operations or repo rate route, will result in more funds with banks. If funds are easily made available to banks at lower rates, they will lend out the same to firms at the same lower rate. Lower borrowing cost for firms results into higher investments in the form of new factories and manufacturing units. This results into higher employment, higher incomes and ultimately  results in higher GDP.

Now let us look at the different types of deficits that we read about daily.

Business Cycles

Curves always matter

Let’s consider an example. Suppose you own a small chocolate factory in India. Most of the major festivals – Diwali, Eid, Dussehra, Christmas etc. lie during the second half of the year. During this festive season, lot of people buy your chocolate boxes to gift their loved ones. So every year, as the second half approaches, your weekly sales start increasing with more and more people buying chocolate boxes. Your weekly sales peak’s sometime in the middle of the second half of the year and then again starts decreasing slowly, as the first half of the next year approaches. It bottoms out during the middle of the first half of the next year and again starts increasing, as the festive half of the year approaches. If you try and plot your weekly sales, it might look something like the chart below. But this chart assumes that you are not growing and on an average, are producing the same number of chocolate boxes every year.

Now suppose, your company is experiencing rapid growth and producing and selling more and more chocolate boxes every year. You are opening new plants and rapidly expanding your operations. So average number of chocolate boxes produced by your firm, in a year, keeps on increasing with time, but you will still be facing same seasonal fluctuation in sales due to festivals. Now in this case, if you plot your weekly sales, it will look something like the chart below.

You can easily extend this concept to the whole economy. In this case we will plot GDP, instead of weekly sales. Now the time period might not be a fixed one, like one year in our example. It could be several years, and cycles could be smaller or bigger. Actual GDP during a period could fluctuate due to reasons like increased investments, reform oriented government, rising consumer spending etc.

During expansionary phase – GDP growth increases, unemployment rate is low and inflation increases. As explained in demand pull inflation, growth in GDP leads to higher income, resulting in higher spending. Increased spending drives prices higher, hence higher inflation. While in the case of contraction – GDP growth decreases (sometimes even becomes negative), unemployment rate increases and inflation decreases. Generally, when an economy enters the contraction phase and experiences two consecutive quarters of negative GDP growth, it is termed as recession.

Indexation

The profit that you make on selling a long-term capital asset is called a long-term capital gain. But as you know, inflation erodes the value of money. For instance, the value of Rs 100 was worth more 10 yrs ago than what it is today. That is why when computing the gains on selling a capital asset, it is important to adjust the purchase price to account for inflation.

This is done by way of indexation, a method used to reduce tax liability on selling a capital gain. Indexation accounts for inflation from the year of purchase of an asset to the year of sale.

How does indexation work?

• It inflates the purchase price of an asset by accounting for inflation until the year of the sale
• It reduces the capital gains you earn on selling an asset
• Finally, it brings down your tax on capital gains

 Before looking at an example, let us understand what are capital assets and capital gains.

Capital asset: This is an asset that you hold for over a year with an intention to not to resell but derive benefits from it for a longer period of time. These can be financial securities, real estate, and so on in the form of short- or long-term assets. But for the purpose of indexation, we shall focus on long-term capital assets—held for 12 to 36 months depending on the asset class.

Capital gain: The profit you earn on selling a capital asset after you have held it for a minimum holding period is called a capital gain. So when you sell a residential property after holding it for at least 3 yrs, the profit you make thereon is a long-term capital gain. Simply put, a capital gain is a difference between the sale price and the purchase price of a capital asset. As with any other taxable income, long-term capital gain also attracts income tax.

For instance, if you had bought a residential property for Rs 10 lakh in Mar 2003 and sold it for Rs 35 lakh in Mar 2020, then you have earned a capital gain of Rs 25 lakh. Here, the property is a long-term capital asset and the profit is long-term capital gain, which attracts income tax. Assuming the rate of tax on long-term capital gains is 10%, your tax liability on the sale of the property would be Rs 2,50,000! But thanks to indexation, you don’t have to pay tax on Rs 25 lakh. Here’s why.

As mentioned, indexation inflates the purchase price of an asset. Keeping the sale price of the asset constant, a lower purchase price increases your capital gain and tax liability. On the contrary, a higher purchase price decreases long-term capital gain and tax thereon. For this purpose, you ascertain the indexed cost of acquisition. Meaning adjusting Rs 10 lakh for inflation over 17 yrs of holding period so it reflects today’s value.

The rate of inflation considered here is derived from the government’s Cost Inflation Index (CII), available on the income tax department’s website. Once you have the CII data, you can calculate the indexed cost of acquisition of the asset or its inflation-adjusted value as follows:

Indexed cost of acquisition = Original cost of acquisition x (CII of the year of the sale/CII of year of purchase)

In our example, the indexed cost of acquisition of the residential property = Rs 10 lakh x (280/105) = Rs 26,66,667

Effectively, the capital gains will now be Rs 8,33,333 (Rs 35,00,000 minus Rs 26,66,667) as against Rs 25 lakh before indexation. Naturally, your tax on capital gain also reduces to Rs 83,333 as against Rs 2,50,000 before indexation.

By now you may have understood the benefit of indexation. It helps reduce your long-term capital gains and, in turn, brings down your overall taxable liability.