Lecture 3: Dynamics of

Economics

Evolution of Modern Economics

Mercantilism
Wealth = power
Limited wealth in world = total wealth in world is constant
One countrys profit, other countrys loss

Laissez-faire
Leave us alone
Invisible hand
Wealth put into market seeks points of profit

Capitalism
Adam Smith: Father of modern Economics

Marxist
Capitalist resources:

Land
Machinery
Capital only contribution of capitalist risk
worker

If you remove workers from above factors, it is absolutely useless

Workers provide essence, therefore, they should get equal share

Socialism vs. Communism

Socialism

Communism

Primarily and Economic

system. Can exist under other
political system
eg. India
Socialism is early stage of
communism
From each according to his
ability, to each according to his
deed
Freedom of religion.
Taxation.

It is a political system. Every

factor of life is controlled by
state. Everyone is government
employee.
eg. China
It is more rigorous form of
socialism
From each according to his
ability, to each according to his
need
State is the religion.
No taxation

National Income
GDP
Total value of final goods produced in the country
Includes the production of foreign companies in India

GNP
GNP = GDP + Income of Indians producing abroad income of
foreigners producing in India
Gross value of production of all Indian citizens only

NDP
NDP = GDP depreciation

NNP
NNP = GNP - depreciation

NNP at factor cost or the National Income

Subsidies reduce the market value of product

Taxes increase the market value of product eg sales tax
National income = NNP + subsidies indirect tax
True production of Indian economy, hence the national income

Financial Administration
Fiscal Policy
related to government money or public money
Income
expenditure
debt

GoI is the highest authority (Ministry of Finance)

Monetary policy
Related to money esp total supply of money in the
economy
Liquidity
Inflation management

RBI is the highest monetary authority of India

Fiscal Policy

*Explain deficits here

itself

Fiscal Policy
Revenue
Money without any liability in the future
Eg. Tax, earnings

Capital
Money with future liability
Eg. Loan, disinvestment

Fiscal Policy

*very less or
nominal
development

Deficit
When country follows expansionary fiscal
policy then
Income < Expenditure

This difference between income and

expenditure is called as deficit
It is good for the country when it is within the
admissible range as deficit implies
Capital investment -> high income in future
Analogous to taking loan for start up

Types of Deficits
Revenue Deficit

Revenue Deficit = Revenue Exp Revenue Inc

Indicates governments level of taxation
Inadequate taxation: great mismanagement
Loan required to maintain -> very bad

Fiscal deficit
It is the difference between total expenditure and total income
excluding borrowing
Indicates governments total borrowing requirement
Fiscal deficit = total expenditure (revenue inc + non-debt
creating capital income)
Fiscal deficit = borrowing at home + loan from RBI + borrowing
from abroad

Types of Deficits
Primary deficit
Primary deficit = fiscal deficit interest on loans
Indicates the principal amount of loan (total loan)
needed
Note that fiscal deficit indicated total borrowing
needed (principal + interest)

Deficit financing
Internal borrowing
RBI
Companies, etc

External borrowing
Other countries
IMF, World Bank, etc

Printing new currency

RBI
Most inflationary

Reserve Bank of India (RBI)

Highest monetary authority
Established in 1935 under RBI Act, 1934
Functions

Issuer of currency
Banker and Debt manager for government
Bank of banks
Inflation control

Scheduled Bank
Bank included in the 2nd schedule of RBI Act
RBI guarantees the payment of deposits to the
depositor

Inflation
Definition:
Rise in prices and consequent loss of value of money
Primarily due to gap between demand and supply
Orignal Supply decreases
due to natural calamities
Increase in cost of production

increased liquidity in the market is the culprit

Increased wages
Low interest loans
Printing of currency
Deficit financing

Bad effects of inflation (Mehengai)

Decrease in value of money
Uncertainty over future
Poor: most affected

Inflation control
Fiscal policy(GoI)

Monetary Policy(RBI)

Supply <------------------------->demand
(Short term: imports
Long term: increased production)

Note: increase in liquidity, increases inflation. RBI takes

measures to control liquidity and hence the demand

Measures of RBI for monetary control

What do the banks do?
Lend and borrow
Margin is the incentive
How does bank affect market liquidity?

Cash Reserve Ratio (CRR)

Amount of money in proportion of deposit kept with RBI

Statutory Liquidity Ratio (SLR)

Proportion of money that bank has to keep with themselves
Cannot lend or use this money
CRR & SLR measures: security of depositors + liquidity control

Repo rate (analogous to interest rate on loan)

Interest rate at which RBI lends to banks for short term loans
Increase in repo rate reduces liquidity

Reverse repo rate (analogous to interest on deposit)

Interest rate at which RBI borrows from banks
Done to reduce market liquidity

Measures of RBI for monetary control

Bank rate
Rate at which RBI lends to banks for long term loans
Increase decrease

Marginal Standing Facility (MSF)

Overnight loans to banks
Pegged 1percent above the repo rate

Open market operations

RBI purchases or sales government securities to general
public to increase or decrease the liquidity in the market

Stop printing of currency

Sterilization
RBIs use of various tools as mentioned above to prevent
sudden shocks to the economy

Evolution of Exchange Rate

How will two countries with different currencies trade?
Currency is limited to nation boundaries

The Gold Standard

Two countries can trade via gold
Gold used as a medium over currency
Gold std: When GDP increases corresponding increase in gold is
not possible
currency printing depended on amount of gold

Constant amount of gold:

Over valuation of domestic currency
deflation -> recession

Contributed to the Great Depression

Bretton Woods System (1944):

Dollar pegged with Gold US had 70 percent of worlds gold
US: promise to pay in terms of gold for dollar

Evolution of Exchange Rate

How did $ solve the problem with gold?
Countries with no gold reserves can ask for dollar
US had the highest reseves

US BoP crisis:

Dollar over valued

Hoarded by other countries
Liquidity crunch
Leads to recession (no investment: everybody is happy to hold
dollar)

Question mark on USs commitment to repay in Gold

Creation of SDR (special drawing rights) in 1967

Paper gold: result of Triffin dilemma
SDR is international reserve asset
SDR can be used as medium of exchange for trading like
gold
Value depends on weighted average of 4 currencies
Dollar, euro, pound sterling and yen

Evolution of Exchange Rate

How did SDR solve problem that arose due to dollar?
Force behind SDR is promise of the IMF members
Virtual asset: So can be multiplied as many times as it is
required (gold problem)
It is not the currency of any country. (US problem)

Released pressure on dollar

Nowadays, both SDR and dollar are used

Nixon Shock: Link between gold and dollar broken

(1971)
After President Nixon
End of Bretton wood system no gold in exchange any
more

Exchange rate
It is determined by the market forces. Self adjusting.

(demand of
dollar)

(quantity ->)

Exchange rate
Plot a vertical line from DD on x axis at the start of DD
line
High price of $, costly imports
Less demands: People will say no to import

Plot a vertical line from DD on x axist at the end of DD

line
Less price of $, cheaper imports
High demand: yes to imports

SS: supply line;

directly proportional to quantity of foreign exchange
Linearly proportional

Point of equilibrium decides value of Rupee per dollar

Exchange rate
Artificially, if Rupee is given high price (fixed
currency regime/value)
Gap between SS and DD; draw a horizontal line
More demand and less supply
Gap bridged by forex reserves of RBI
Leads to exhausting of forex reserves

If not enough forex reserves, BoP crisis eg. 1991 India

Better to go for floating regime/value -> value decided
by market
RBI intervenes only to stabilise economy -> gives time
to the investors to adopt
Shock absorber

Few Factors affecting Exchange

Speculation
People speculate that in future, dollars value may increase
Greater demand for $

Interest rates of commercial banks

Banks in USA offer higher interest rates on deposits
Business men from India will prefer depositing money in USA;
higher demand

Technological advancement
Good or service in India is for Rs 100
Same is available for Rs 80 in USA -> technology; higher demand

Education facilities

Eg. USA opens 100 more seats in MIT

People from India will go abroad
Effectively, import of education
Greater demand for $; rupee will depreciate

Note: DD in graph will shift upwards in all these cases

Forex
Forex
Forex stands for foreign exchange
Reserve of foreign currency held by RBI

Need of forex by RBI

For financing imports
Stabilizing currency

Sources of forex for RBI

Export
Remittances:
eg. Gulf emigrants send money back to India

FDI and FII

Loans

Balance of Payment (BoP)

BoP equilibrium
Essentially, exports and imports are at par

Negative BoP
Imports greater than export

Stages in crisis
First there is revenue deficit
Loan for development as well as maintenance
Fiscal deficit

Fiscal crisis: large or further fiscal deficit

In this situation, no body wills to lend; you already have lot of debt

BoP Crisis: Fiscal crisis + imports far more than export +

no Forex with RBI
Nobody lends forex as well
IMF lender of last resort

Foreign Direct Investment

Definition: When a foreign institution tries to
show its direct presence in some other
country then it is called FDI
Presence is in terms of having >
Long term investment
Installing their own assets
Showing its direct ownership
Taking sole responsibility of the management

Foreign Investment
Need of Foreign investment
Investment capital: when domestic investors and
government lack it
Forex reserves
Helps to bridge the deficit

Need of FDI
Infrastrure and Development
Employment generation
Transfer of technology
Eg Defence

Competition in market

Disadvantages of FDI
Politically driven reasons
Unemployment breaking of chain no job
opportunities for intermediaries

WWE Wrestler vs. Common Man

Need for a strong domestic private sector
Time should be given to the domestic sectors to
be ready
This time was given upto 1991 after Independence

Why is FDI less in India?????

You have to explain the answer after I explain
the factors affecting investment

Where will you invest?

Guys planning to start a start up answer this question
Factors affecting investment?
Pakistan/Ukraine or Switzerland??
Political stability

India or Australia (assuming similar political and economic

circumstances) ??
Population: huge market
High growth of population: prospects for business
Corollary of High Population: cheap labor

US or India?? (assuming US has 1.25 Billion population :P)

Governments policy
Technological advancement

Foreign Institutional Investment (FII)

When a foreign institution invests in some other
institution in a country without showing direct
presence
Here, the investment is similar to the one in the share
market
No participation in management
No long term interest

Disadvantages
More inflationary than FDI
Sudden withdrawal of money
Leads to too many people chasing too few goods
Shock to the economy

Criticism of Economics
Largely based on estimation
Proper explanation of the activities largely
unexplained

Too stastical and mathematical

Figures and indexes given more importance
Economists mostly fail to take into consideration
the human factor
CGPA vs Knowledge

Polity revision

Thank You!