Economic Fundae - Interest Rates

It is a really a good time to start with the economic fundamentals as there is so much happening across the globe with recession and our phenomenal growth story. It becomes easy to see what we are discussing in theory in the real life. Inflation is something most of the developing nation is fighting against. At least in India, the Reserve Bank of India has done a great job in controlling the soaring price rise that happened in 2007. But what are the policy that RBI has at its disposal to control inflation? These are largely the tools and policies different from the fiscal policy.

Before answering this question we will look into one of the important macroeconomic variable which connects the present with the future – Interest Rates. The rates which our bank pay is called as the nominal interest rate and this measure the increase in the value of the money we hold. It can be seen as the amount that we get paid for forgoing the consumption at present.

The other class of interest rates is called the real interest rates which are essentially the increase in the purchasing power. Think of a capital as a corn seed. The increase in value from the seed to the corn is the real increase in value. But due to the general increase in prices of other commodities – inflation our corn will fetch us more money than the actual value. This is called the nominal value which is the real value plus the inflation.
R = I – πe
This equation gives the relationship between the real interest rate and the nominal interest rate & inflation rate.

Why is there a fluctuation in the interest rate? This is dependant on the amount of money in circulation. Now the big question is whether the RBI sets the interest rate or sets the money circulation? It sets the money supply.

It is done through a series of steps called as the open market operations. In this the central bank buys bonds – a debt instrument, in exchange for money, thus increasing the stock of money, or it sells bonds in exchange for money paid by the purchasers of the bonds, thus reducing the money stock.

Now ask yourself this question, what will happen to the exchange rate if the central bank sells $1 billion from its foreign currency reserves?

We fairly understood about the strict monetary policy. Now it is time to see what is happening in the scenario of recession. The U.S central bank has announced a interest rate cut in order to combat the recession. By cutting interest rates the FED would be boosting U.S economy by making it cheaper to borrow. But it has its implication also in the spending habit. This artificial intervention of the central bank is rarely seen unless it is absolutely necessary to do so.

The other side is the reduction in the earnings due to the interest rate cut. This will immediately give arbitrage opportunity for investors to borrow money from the U.S banks and invest in a country like India where the interest rates are higher. Sensible isn’t? But is it what our finance minister will also be happy about? We will see in the subsequent article of the critical analysis of the forth coming budget and the interdependency of the various macroeconomic variables we have learnt so far.

Economic Fundae - Fiscal Policy

The big question that our finance ministry will face is how to react to the global recession and our stock market crash. Although these are issues which need correction from various economies, let us see what tools are at hand to control the economic fluctuation. Last year -2007 although we saw our GDP grow more than 8%, we were facing with issues like inflation. The Reserve Bank of India which is the principle organization in command of our economy was taking numerous measures to curtail inflation. What essentially were they doing? What is the role of government in these situations?

Fiscal Policy is use of government spending or tax policy to control aggregate demand-
The taxes that we pay are essentially the source of funds for our government. Now what kind of taxes we pay? Where does the money go?

To understand this we will revisit the equation which is worth remembering
GDP = C + I + G -NX

The G – Government spending composes of two components, the purchases of goods and services & government transfers – which include government spending on individuals without expecting any goods or service. In India we can think of this as the spending towards to rural development and poverty alleviation. But targeting government expenditures simply to reduce poverty is not sufficient; government needs to stimulate economic growth to help generate the resources required for future government expenditures. This becomes the rationale for a budget deficit.

The government can influence the consumer spending by controlling the taxes and the transfers. This is sensible because the more the tax we pay the less is our disposable income – which is our revenues minus the taxes (total income available to spend).

Now why would our government want to control aggregate demand? This is just to control the effects of recession – “Refer Economic Fundae – Business Cycle” or inflationary pressure.

What could it possibly do?
1. Increase government spending
2. A tax cut
3. A increase in government transfers.

This could be the opposite when our government has inflationary pressure.

But remember it is not that easy and it is not that fast to bring in a change. There is also a concept of multiplier to the effect of government spending- it is the ratio of the change in GDP to the change in aggregate spending. In simple terms if you sow Rs 100 you may end up reaping 200!

This multiplier effect may not be there if the government policy is to cut taxes or increase government transfers. This is because not all of the tax benefit you get may be spent, which is given by the marginal propensity to consume.

Now the budget is just a few weeks ahead, we often hear the terms like budget deficit (at least in my generation I have not heard of a budget surplus). What it means? Whether budget deficit is good or bad?

The budget balance is equal to the government savings which is governed by the following equation
S = T – G – TR
T- tax receipts
TR – Transfers

In general, the government runs budget deficits, when there is a recession and surplus when there is economic expansion. In India we have seen the politicians have the habit of wooing the voters by having a tax cut and hence a deficit budget. By doing so, Indian government have run in deep debts. Remember the interest payments for these debts, which are also funded by the taxes that we pay.

Now a novice person like me would think what if the government would print more money to fund the debts. Remember there is always a problem with the inflation.

Now you are all set to think in terms of the finance ministry tools. In the next article we will see how the central bank controls inflation.

Economic Fundae - Business Cycles

Macroeconomics as a discipline is about the study of national economy, total output level, the general trend in employment. All this not only nation wide but also with respect to the global economy. I write this article as the stock market tanked 4000 points roughly about 20% in two days in reaction to the global recession- economic downturn. In the past century we have seen years of boom and bust between years, which is called the business cycle. What is happening today in the stock markets can be only a fraction of the impact which was there during the Great Depression- stock market crash of October 1929, but we can immediately strike a relationship in these events. But why is there business cycle, and what are reasons for the recession? This is a subject we are currently dealing with.

In fact we all would agree to the fact that the salary we get today is at least twice as much as our parents. This even after adjusting for inflation- which is the rise in the price level of goods and services have grown phenomenally. This is attributed to the long run growth of an economy. We are trying to address the issue of growth in the long run and the intermediate recession and expansion.

For an engineer turned management graduate like me trying to understand this phenomenon of recession would immediately associate with the unemployment, the effects of aggregate output and the government policy on these issues.

Looking at the issue of unemployment- the percentage of total number of people in the labour force who are unemployed. In general we have higher unemployment rate during recession and lower during expansion. The policy measures which are undertaken to stabilize the severity of the recession or to rein in the expansion are the Monetary Policy - which involves changes in the money, interest rates etc. & the Fiscal Policy- which involves changes in the tax policy or government spending etc.

Before going further to the discussion of recession, we will define what an open economy means. Until 1991, India had the policy of restricted trade regime, which essentially is the closed economy - the economy which does not trade goods or services with other countries, self sustained. This principle goes against what Adam Smith in his book mention of division of labour. A country should try and maximize its production in which it is generally good at. It is more of a focused approach rather than channelizing to all what an economy needs.

After 1991, India opened its economy to the world because of the crunch and the request by IMF to do so. Hence an open economy is one which trades with other countries. This is different from the closed economy dynamics with the exchange rates - which is discussed in the previous article.

There are numerous reasons for recession and it is measured by looking into the amount of business activity which is happening- Unemployment, industrial production etc. One should remember the effect of the "Paradox of thrift" - which is the reduction in spending forecasting a economic hard time actually leads to a slump in the economy and the business begins to layoff.

There were enough cues this time for the U.S economy slowdown and one article in our blog addressed the issue of "Merrill Lynch faces huge loss due to bad mortgage write-downs".

Long run growth is about the general increase in the standard of living. But remember we are all dead in the long run!!!

Economic Fundae - Exchange Rates

In any system it pays to standardize. Essentially this is been the case in every development over the years. We have always tried to find new opportunities in standardizing processes which will improve efficiency.

This can also be seen in the international trade, where people had looked into ways of standardizing the exchange of goods and service. We need to go back to history to see how gold standard worked and what lead to the Bretton Woods system. Much of our worries about raising rupee against dollar dates back to one of greatest move in history by the then President Roosevelt abrogated contracts in which payment was specified in gold.

This system in simple terms made countries to settle their internaional balances in U.S dollars, while the U.S. government redeemed other central banks holdings of dollar for gold at a fixed exchange rate of $35 per ounce. This system came to an end when U.S government was no longer able to redeem dollar for gold in 1971.

Now another question emerges as we probe further into the currency maintained by a country. How will the country decide on their currency?. What should be the growth rate of the currency?. What should be the quantity of the currency?

Gold standard served two purpose, one the domestic standard trying to determine the currency quantity and the rate of growth of money supply. This worked in tandem with the world's gold stock.

Next Gold also provided a standard for the international exchange. Consider the scenario in which U.S fixed the price of gold at $20 per ounce, and the U.K government fixed it at £4 per ounce, then the exhcnage rate equalled $5 per pound. This is called as the fixed exchange regime.

After 1971, we have the floating exchange rate. This works in a simple rule that the central bank of a country will not intervene in the rates set by the market. Hence the demand for a particular currency helps in determining the rates. This demand is because of the larger acceptance of the goods and services of a particular country.

Lets understand the rules of the floating exchange rates more and its interaction with the interest rates and inflation in the subsequent articles.

Economic Fundae - Inflation

Inflation in simple terms is the loss of purchasing power of a currency. If today 10kg of general items can be bought of 100 Rs, then after a year how much money will be required to buy the same amount of goods? Inflation gives an idea of that general increase in price of goods.

There are standard ways to measure inflation such as the Wholesale Price Index (WPI) and Consumer Price Index (CPI). WPI measures the increase in price of basket of goods at the wholesale level. It is measured weekly. CPI gives the measure of the cost of given basket of goods (Wheat, Pulse etc) and services which the consumer has to pay. CPI is always greater than WPI.

Although there are inherent problems with this measure which is largely attributed to the weights attached to the goods and services and also the changing quality which is very hard to quantify. This of course can have huge difference in the policy decisions. There can also be a cumulative wrong measurement due to these inherent problems in scientific methods in economics.

Now if we were to answer what an effect does it has on policy making and the other variables in macroeconomics, we need to understand a bit more of how the Monetary Policy and fiscal policy is taken.