Economics 101

Economics 101

Micro & Macro

EconomicsRahul Reddy

Economics is the science of the optimum or best utilization of economic resources

Microeconomics Basics

Some definitions

• Demand

• Supply

• Consumer

• Customer

• Complementary Good

• Substitute Good

Some definitions

• Demand

• Supply

• Consumer

• Customer

• Complementary Good

• Substitute Good

Some definitions

• Demand

Demand is the want or desire to possess an economic good, backed by the necessary financial capability to buy that good, at a given price.

Some definitions

• Demand

• Supply

• Consumer

• Customer

• Complementary Good

• Substitute Good

Some definitions

• Supply

Supply is the total quantity of an economic good that is available for purchase at a given price

Some definitions

• Demand

• Supply

• Consumer

• Customer

• Complementary Good

• Substitute Good

Some definitions

• Consumer

An individual who acquires an economic good for direct use or ownership and not for resale or use in production of some other economic good

Some definitions

• Demand

• Supply

• Consumer

• Customer

• Complementary Good

• Substitute Good

Some definitions

Customer

An individual who purchases an economic good for self or on behalf of the consumer.

A customer may be different from the consumer, eg:

1. Government purchasing oil from the OPEC for consumption by the population

2. Parents purchasing baby food for consumption by the infant

Some definitions

• Demand

• Supply

• Consumer

• Customer

• Complementary Good

• Substitute Good

Some definitions• Complementary good

An economic good which is usually used along with another good

Examples

1. Tea: milk, sugar

2. Pen: ink, paper

Some definitions

• Demand

• Supply

• Consumer

• Customer

• Complementary Good

• Substitute Good

Some definitions• Substitute good

An economic good which is usually used in place of another good

Examples

1. Tea: coffee, cold drinks

2. Pen: pencil, crayon, brush

Marginal Utility

Marginal utility of water

The utility, and therefore demand, of every incremental unit of water diminishes

⇒ Price equals marginal utility⇒ If price reduces, demand

increases

∆

Law of demand

The higher the price of an economic good, the lower is its quantity demanded, ceterus paribus.

Demand Curve of a normal economic good is downward sloping

Factors affecting demand• Income

• Tastes and Preferences

• Price of complement goods

• Price of substitute goods

• Price expectations of the customer

• Number of customers (at a macro level)

Exceptions to law of demand

• Veblen Good

• demand increased with price

• Luxury products (snob value)

• Price is only indicator of quality

• Giffen Goods

• demand rises as price rises

• Inferior cereals, essentials

Price Elasticity of Demand• Change in demand /unit change in price

• Price Elasticity = ∆D/∆P

• High elasticity

• Non essential goods

• Goods with close substitutes

• Low elasticity

• Essentials, without close substitutes

• Price is set largely by supply

Income elasticity of demand

• Unit change in demand per unit change in income of people demanding the good.

• eI > 1 for luxury goods

• e.g. 10% Higher income --> 20% Higher Demand

• Higher disposable income

• eI < 1 for goods of necessity: Engel’s law

• Consumption of essentials does not rise

• eI < 0 for inferior goods

• As income rises consumption --> substitute goods

Law of supplyThe higher the price of an economic good, the higher

is its quantity supplied, ceterus paribus.

Supply Curve of a normal economic good is upward sloping

Factors affecting supply• Price and availability of resources

• Price of complement goods

• Price of substitute goods

• Technological changes

• Price expectations of the seller

• Taxes and subsidies

• Number of sellers (at a macro level)

Equilibrium

Surplus

Shortage

Equilibrium price and Equilibrium quantity

Market : self balancing tool • If Demand is high, price goes up

• Consumers curtail demand

• Higher profits invite fresh suppliers

• If Supply is high, price goes down

• some suppliers go out of business

• Low price increases demand

• Market promotes efficiency

• Inefficient suppliers are weeded out

• Allocation of resources based on demand

Macroeconomics Basics

Gross Domestic Product, GDP

Total market value of all final goods and

services manufactured within the country in a financial year

=

Household Consumption + Investment + Government Expenditure + Net Exports

(Consumption approach)

=

Wages + Interest + Rent + Profit + Indirect Tax + Depreciation

(Income approach)

Gross National Product, GNP

Total market value of all final goods and

services manufactured within the country in a financial year plus net

factor income from abroad

=

GDP + Income earned by Indians from foreign investments – Income earned by foreigners from domestic investments

Consumer Price Index, CPI

CPI is a measure of the level of inflation.

CPI measures how much the price of a basket of consumer goods has changed

over a given time period.

In India CPI is computed weekly and is measured YoY and WoW

Wholesale Price Index, WPI

WPI is a measure of the level of inflation from an industrial point of view.

WPI measures how much the price of a basket of wholesale goods has changed

over a given time period.

Generally WPI leads the CPI by 60 – 90 days

Current Account Convertibility

Freedom to exchange the Rupee into other currencies

In connection with Foreign trade and other normal business functions.

Payments due - as interest on loans and as net income from other investments

Individual remittances for family living expenses

Business travel, participation in overseas conferences, studies abroad, training or medical treatment

Capital Account Convertibility

Home currency can be freely converted into foreign currencies for

acquisition of capital assets abroad or for any purpose.

The rupee is currently not freely convertible on the capital account.

Purchasing Power Parity, PPP

• A method of measuring the relative purchasing power of different countries’ currencies over the same types of goods and services.

• Allows us to make more accurate comparisons of standards of living across countries.

• Not all items can be matched exactly across countries and time, the estimates are not always "robust”

• India is # 4 in GDP (PPP) terms and # 10 in GDP (nominal) terms worldwide

Foreign Direct Investment, FDI

Foreign Direct Investment (FDI) is investment into physical assets of other countries,

• Through financial collaborations.

• Through joint ventures and technical collaborations.

• Through capital markets via Euro issues.

• Through private placements or preferential allotments.

Areas prohibited under FDI:

• Arms and ammunition.

• Atomic Energy.

• Railway Transport.

• Coal and lignite.

• Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper, zinc.

Foreign Institutional Investors, FII

FII means an entity established or incorporated outside India which proposes to

make investment in India. (Shares less than 10% of total voting shares)

In India, the Following entities / funds are eligible to get registered as FII:

• Pension Funds & Mutual Funds

• Insurance Companies

• Banks & Investment Trusts

• University Funds

• Endowments, Charitable Trusts / Charitable Societies, Foundations

Fiscal Policy

The government’s policy of achieving economic objectives (employment, per capita income…) through government earning and spending.

Monetary PolicyThe government’s policy of achieving

economic objectives (employment, per capita income, balance of trade, economic parity…)

through controlling money supply

Decrease in supply: Deflation or decrease in prices

Increase in supply: Inflation or increase in prices

MONEY SUPPLY• M1 = currency in circulation - cash with

banks + demand deposits with banks

( also called narrow money – most liquid )

• M2 = M1+ small saving deposits

• M3 = M1+ time deposits with banks

( also called broad money )

• M3 > GDP → Inflation.

MONETARY POLICY

Regulates the money supply in the economy

1. Repo Rate.

2. Reverse Repo Rate.

2. Open market operations - RBI buying and selling securities to regulate money supply.

MONETARY POLICY3. A) CRR - every commercial bank to keep a

certain percent of it’s demand and time deposits with the RBI.

B) SLR - commercial banks keep a fixed percentage of their demand and time deposits in liquid assets ( cash, securities, gold ).

4. Priority sector lending

5. Differential Interest Rates ( PLRs )

Interest Rates

• Interest rates – Tool of monetary policy

• Low interest rates

• Incentive to borrow: Consume/Invest

• Used with Hi money supply

• High Interest rates

• Incentive to Save

• Used with Low Money supply

• Used to control Inflation

ROLE OF THE RBI

• Issue of bank notes of all denominations

• Regulates money supply

• Lender of last resort to banks

• Controls FOREX operations.

Fiscal Policy

• Fiscal or Budgetary Policy is the policy involving Government revenues and Expenditure

• Objectives:

• Economic Growth

• Inflation control

• Employment generation

• Social sector objectives

TAXES

• DIRECT TAXES

Direct incidence of tax on the person who pays the tax. liability to pay tax is NOT passed on to someone else. e.g. INCOME TAX, CORPORATION TAX, WEALTH TAX, LAND REVENUE, GIFT TAX etc….

• INDIRECT TAXES

Levied on goods and services. traders / producers pay it. Liability passed on to end customer. e.g. VAT, EXCISE TAX, CUSTOMS DUTY, SERVICE TAX…

Taxes as fiscal tool

• Government uses Taxes

• Revenues

• Price Control

• Stimulate investment

• Promote Balanced Economic growth

• Suppress sale of Negative goods

STRUCTURE OF UNION BUDGET

REVENUE SIDE

1. Revenue receipts

A) tax revenue — central excise, customs duty, corporation tax, income tax, service tax, FBT, CTT, STT.

B) non-tax revenue —interest receipts on loans , profits from PSUs.

2. Capital receipts

Dividends from PSUs, principal repayment from debtors, disinvestment proceeds , market borrowings.

Revenue and Capital Expenditure

• Revenue Expenditure: Expenditure which is not directly linked to creation of asset. e.g. Salary payment, Consumable purchases etc

• Capital expenditure: Expenditure that leads to the creation of assets. (Investment). e.g. Purchase of machinery or durable.

DEFICITS

• Revenue deficit

Revenue expenditure ( interest + subsidy + defense + law and order) — revenue receipts

( tax + non tax)

• Budget deficit

Total expenditure - total receipts (incl borrowing)

• Fiscal deficit (Real Deficit)

Budget deficit + borrowings from banks and public

DEFICIT FINANCING AND IMPACT

• Government borrows from RBI by transferring securities. RBI prints new currency and lends to the govt.

• Increases money supply. Adds inflationary pressure in economy.

• Reduces funds available for private borrowers.

• Government ends up paying more interest in future.